For an asset that should be easy to value and analyze, cash has been in the news a lot in the last few months, both when it has been returned (in buybacks especially) and also when it has been accumulated either domestically or offshore. Since companies have always returned cash and held cash balances, you may wonder why these stories are news worthy but I think that the cash is under the spotlight because of a convergence of factors, including the rise of technology companies in the market cap ranks, a tax law in the US that is increasingly a global outlier, and low interest rates.

Accounting for, Valuing, and Pricing Cash

In pricing, the tool used in comparisons is usually a multiple and the most commonly used multiple is the PE ratio. To set the table for that discussion, I have restated the intrinsic value balance sheet in the form of PE ratios for the software business, cash and equity overall.

The PE ratios for software and cash are computed by dividing the intrinsic values of each one by the after income generated by each. The PE ratio for cash can be simplified and stated as a function of the risk free rate and tax rate:

The PE ratio for cash is much higher than the PE for software (11.81) and it is pushing up the PE ratio for equity in the company to 14.11. Put differently, if the stock is priced based on its intrinsic value, it should trade at a PE ratio of 14.11.

How will bringing in debt into this process change the game? Let's assume that you borrowed $300 million and bought back stock in this company, while leaving the existing cash balance unchanged. Reducing your market cap by roughly $300 million will augment the effect of cash on PE and make the non-cash PE ratio even lower.

Cash Balances and PE: Determinants

Thus, a cash balance that amounts to 20% of firm value will push PE ratios from 15.38, when the short-term, risk free rate is 1% and to only 14.08, when it is 5%.

The US Market: PE and Cash
At this point in this discourse, you may be wondering why we should care, since companies in the US have always held cash and had to earn close to a short-term risk free rate on that cash. That is true but we live in uncommon times, where risk free rates have dropped and corporate cash holdings are high, as is evidenced in this graph that looks at cash as a percent of firm value (market value of equity+ total debt) for US companies, in the aggregate, from 1962 to 2015 and the one-year treasury bill rate (as a proxy for short term, risk free rates):

Data from Compustat & FRED: Computed across all money-making companies

Sector Differences in Cash and PE

In the second part of the analysis, I computed the cash effect on PE for individual companies and then looked at the distribution of this cash effect across all companies:

It delivers the message that there is no simple rule of thumb that will work across all companies or even across companies within a sector.

Perhaps, the best way to check out the effect of cash on PE is to pick a company and take it through the cleansing process, a very simple one that requires relatively few inputs. Use this spreadsheet to try it on your favorite (or not-so-favorite) company.

Rules for dealing with cash

Spreadsheets

1. Intrinsic value of cash and operating assets (to back up example in post)
2. PE Cleanser (to compute non-cash PE for a company)

Datasets

1. Cash and non-cash PE ratios by year: All US companies
2. Cash and non-cash PE ratios by sector in 2014

In my last post, I looked at the leavening effect that large cash balances have on PE ratios, especially in a low-interest rate environment. In making that assessment, I used a company with no debt to isolate the effect of cash, but many of the comments on that post raised interesting points/questions about debt.

The first point is that while cash acts as an upper for PE, debt can act as a downer, with increases in debt reducing the PE ratio, and that if we are going to control for cash differences in the market across time, we should also be looking at debt variations over the years.

The second is the question of which effect on PE dominates for firms that borrow money, with the intent of holding on to the cash. In this post, I will start by looking at debt in isolation but then move to consider the cross effects of cash and debt on PE.

Debt and PE: A simple illustration

To examine the relationship between PE and debt, I went back to the hypothetical software firm that I used to evaluate the effect of cash on PE. Initially, I assume that the firm has no cash and no debt and is expected to generate $120 million in pre-tax operating income next year, expected to grow at 2% a year in perpetuity. Assuming that the cost of equity (and capital) for this firm is 10%, that the tax rate is 40% and that its return on equity (and capital) on new investments is 36%, the company's income statement and intrinsic value balance sheet are as follows:

Now, assume that this firm chooses to move to a 40% debt ratio with a pre-tax cost of borrowing of 4%. The effects of the debt on the are traced through in the picture below:

Note that the value of the business has increased from $850 million to $988.37 million, with the bulk of the value increase coming from the tax subsidies generated by debt.

The effects of borrowing show up everywhere, with almost almost every number shifting, and the effects at first sight seem to be contradictory. Higher debt raises the cost of equity but lowers the cost of capital, reduces net income but increases earnings per share and results in a lower PE ratio, while increasing the value per share. The intuition, though, is simple. Borrowing money to fund the business increases both the expected returns to equity investors (captured in the EPS increase) and the riskiness in those equity returns (pushing the PE ratio down) and at least at a 40% debt ratio, the benefits outweigh the costs. In fact, if you are able to continue to borrow money at 4% at higher debt ratios, the PE ratio will continue to drop and the value per share continue to increase as the debt ratio increases.

Note that at a 90% debt to capital ratio, the PE ratio drops to 2.75 but the value per share increases to $11.41. If it is sounds too good to be true, it is, because there are two forces that will start to work against debt, especially as the debt ratio increases. The first is that the rate at which you borrow will increase as you borrow more, reflecting the higher default risk in the company. The second is that at a high enough debt level, with high interest rates, the interest expenses may start to exceed your operating income, eliminating the tax benefits of debt. In the table below, I highlight the effects on PE and value per share of different borrowing rates:

Numbers in red are declines in value/share

The breakeven cost of borrowing, at least in this example, is around 8.6%; if the company borrows at a rate that exceeds 8.6%, debt reduces the value per share. The effect on PE, though, is unambiguous. As you borrow more money, the PE ratio decreases and it does so at a greater rate, if the borrowing rate is high.

Debt, Cash and PE: Bringing it all together

Now that we have opened to the door to cash and debt separately, let's bring them together into the same company. A measure that incorporates both cash and debt is the net debt, which is the difference between the cash and debt balances of the company.

Net Debt = Total Debt - Cash and Marketable Securities

This number will be negative when cash balances exceed total debt, zero, when they offset each other, and positive, when debt exceeds cash. In the table below, I have estimated the PE ratio for the company with different combinations of debt ratios (from 0% to 50%) with cash ratios (from 0% to 50%), with debt borrowed at 4% and cash invested at 2%:

Numbers in red are declines in value/share

Note that both the cash effect, which pushes up PE ratios, and the debt effect, which pushes down PE ratios, is visible in this table. Interesting, a zero net debt ratio (which occurs across the diagonal of the table) does not have a neutral effect on PE, with PE rising when both debt and cash are at higher values; thus the PE when you have no cash and no debt is 11.81, but it is 12.66 when you have 40% debt and 40% cash. Before you view this as a license to embark on a borrow-and-buy treasury bills scheme, note that the value per share effect of borrowing money and holding it as cash is negative; the value per share declines $0.22/share when you move from a net debt ratio of zero (with no debt and no cash) to a net debt ratio of zero (with 40% debt and 40% cash). Again, there is no mystery as to why. If you borrow money at 4% and invest that money at 2%, which is effectively what you are doing when cash offsets debt, you are worse off than you would have been if you had no cash and no debt. In fact, the only scenario where the value effect of borrowing money and buying T.Bills is neutral is when you can borrow money at the risk free rate but even in that scenario, the PE ratio still increases. In short, the cash effect dominates the debt effect and you can check it out for yourself by downloading the spreadsheet that I used for my computations.

Cash and Debt Effects on PE: US Stocks from 1962 to 2014

In my last post, I noted the difficulty with dealing with cash balances at financial service firms, where the cash serves a very different purpose than it does at non-financial service firms. That statement is even more applicable when it comes to debt, since debt to a financial service firm is less a source of capital and more raw material. Hence, I will focus entirely on non-financial service firms for this section. The first set of statistics that I will estimate relate to debt and cash. In the graph below, I look at cash as a percent of firm value (estimated as market capitalization plus total debt), total debt as a percent of that same value and the net debt ratio (the difference between total debt and cash, as a percent of value) for non-financial service firms in the US from 1962 to 2014.

Raw data from Compustat: All money-making, non-financial service firms

Note the median values for cash and debt are highlighted on the graph. In 2014, the cash holdings at non-financial service companies in the US amounted to 7.30%, higher than the median value of 7.23% for that statistic from 1962 to 2014, and the total debt was 24.20% of value, lower than the median value of 28.39 for that ratio from 1962 to 2014. Since cash pushes up PE ratios and debt pushes down PE ratios, the 2014 levels for both variables are biasing PE ratios upwards, relative to history.

Unlike the cash effect, which I was able to measure with relative ease by netting cash out of the market capitalization and the income from cash from the net income, the debt effect is messier to isolate. If you assume that cash is the only non-operating asset (i.e., that companies do not have cross holdings and other non-operating investments), the debt effect can be computed approximately. First, if cash and debt is zero for a company, and there are no other non-operating assets, the net income for that company will be its after-tax operating income (EBIT (1-tax rate)). Second, the value of the company, if it it had no cash and debt, can be approximated with its enterprise value, leading to the EV/EBIT(1-t) providing an approximate measure of what the earnings multiple would have looked like with no cash and no debt. (The enterprise value does include the value effect of debt and is hence not a clean measure of what the value would have been, if the firm had no debt and no cash.)

Debt Effect = EV/ EBIT (1-t) - Non-cash PE

To estimate these numbers for my sample, I used the average effective tax rate each to compute the after-tax operating income in that year, in recognition of the reality that US companies would not be paying the marginal tax rate on taxable income, even if they had no interest expenses. The graph below summarizes the cash and debt effects on stocks from 1962 through 2014:

Source: Compustat; All money-making, non-financial service US firms

At the end of 2014, the PE ratio was 17.73, the non-cash PE was 16.05 and the EV/EBIT(1-t) was 19.44. So, what do these numbers mean? All three measures are higher than the median values over the last 55 years, which would be ammunition you could use to argue that stocks are overvalued. However, as I noted in my post on PE ratios last year, the treasury bond rate, at 2%, is also much lower than the historic norm, and if you don't buy into the bubble story, could be used to explain the higher multiples. I don't this post is the forum for examining the heft of these arguments, but I did try to provide my views in this post last year on bubbles.

PE Ratios: Three Rules for the road

Like most investors, I like the simplicity and intuitive feel of PE ratios, but they are blunt instruments that can get us into trouble, when used casually. A low PE ratio can be indicative of cheapness, but it can also be the result of high debt ratios and low or no cash holdings. Conversely, a high PE ratio can point to over priced stocks, but it can be caused by high cash balances and low debt ratios. Based on the last two posts, I would suggest three simple rules for the use of PE ratios.

1. When comparing PE ratios across companies, don't ignore cash holdings and debt. As the diversity of companies within sectors increases, the old notion of picking the lowest PE stock as the winner is increasingly questionable, since you may be choosing most highly levered company in the sector.
2. When comparing PE ratios across time, don't ignore cash holdings and debt. In these last two posts, I have noted the ebbs and flows in both cash as a percent of firm value and debt as a percent of value across time, sometimes due to shifts in the numerator (cash and debt values changing) and sometimes due to shifts in the denominator (market value of equity changing). Whatever the reasons, these shifts can affect the PE ratios for the market, making it look expensive when cash balances are high and debt ratios are low.
3. Any corporate action that changes the cash or debt as a percent of value will change the PE ratio. Consider a company that has a large cash balance and is planning on using that cash to buy back stock. Even if nothing else changes, the PE ratio for the company should decrease after the buyback, as (high PE) cash leaves the company. Thus, the practice of forecasting earnings per share after buybacks and multiplying those earnings per share by a constant PE will overstate value. This effect will be even more pronounced, if the company borrows some or all of the money to fund the buyback, since a higher debt ratio will also push down the PE even further.

Finally, if you are at the receiving end of an investing pitch (that a stock or market is cheap or expensive), based just on PE ratios, you should be skeptical, no matter how credentialed the person making the pitch may be, and do your own due diligence.

Spreadsheets
Debt, Cash, PE and Value: An intrinsic value

Datasets
Debt, Cash and Earnings Multiples: US non-financial service stocks - 1962-2014

A unicorn is a magical beast, a horse-like, horned creature that is so rare, that even in mythology, you almost never run into a blessing of unicorns (which, I have learned is what a group of unicorns is called). It was perhaps the rarity (and magic) of private businesses with billion-dollar valuations that led Aileen Lee, founder of Cowboy Ventures, to call them unicorns, in 2013, but as their numbers increase by the month, it may be time to rename them after a species that is more common and less magical. While there are several provocative questions that surround the rise of unicorns, this post is dedicated to a very specific question of how the investor protections that are offered to venture capitalists at the time of their investments can not only affect the measurement of value and make non-unicorns look like unicorns but also skew the behavior of both investors and owners.

A Blessing of Unicorns

One of the best visuals that I have seen on the rise of Unicorns is in this Wall Street Journal article, and it not only allowed you to see the rise of individual companies but compare the numbers over time. In June 2015, there were 97 companies that had values that exceeded a billion, with Xaomi and Uber leading the list, with valuations in excess of $40 billion. The breakdown of Unicorns globally is captured in the pie chart below:

Source: Wall Street Journal

Not surprisingly, the vast majority of unicorns are US-based, though the number of Asian entrants into the ranks is increasing. Looking at the sectors across which these unicorns are sprinkled, the WSJ article provides the following breakdown:

Source: Wall Street Journal

The explosion in the numbers of these companies has also given rise to almost as many explanations for the phenomena, some based on rationality and some on the prevalence of a bubble. The rationality-based explanation for the surge in unicorns is that it has become easier to remain a private business, as private capital markets broaden and become more liquid, while it has become more costly to become a public company, with increased disclosure requirements and pressure from investors/analysts. The less benign argument is that investors are being driven by greed to push up the prices of young companies and that this has all the makings of a bubble. I think there is truth in both arguments and that you can have both good reasons for the increased number of large value private businesses and momentum driven froth in the market. However, I will leave that discussion to those who know more about these young companies than I do, and are more confident in their capacity to detect bubbles than I am.

1. Pre versus Post Money
In an earlier post on the offers and counter offers that you see on Shark Tank, the show where entrepreneurs pitch business ideas and ask competing venture capitalists for money, I drew the distinction between pre and post money valuations. If the capital raised in an offering is held by the company, rather than used to pay down debt or owners's cashing out, the value of the company increases by the amount of the new capital raised, leading to the following distinction between pre-money and post-money values.

• Post-money valuation = Investor's capital infusion/ Percentage ownership received in exchange
• Pre-money valuation = Post-money valuation - Investor capital infusion

In the example above (where an investor invests $100 million for 10% of a firm), the post-money value is $1 billion but the pre-money value is only $900 million. Thus, companies that are smaller than a billion can make themselves look like billion dollar companies, if they are willing to give up enough ownership in the company and can find investors with deep pockets.

While it is unlikely that you will be able to find an investor to offer $950 million in capital for a business with a $50 million valuation, it does illustrate why post money valuations may not always be comparable across businesses.

While the difference between pre and post money valuations is easy to handle, there is another aspect of venture capital investing that is more messy. Many venture capital investors are offered protection against downside risk on their investments, though the degree of protection can vary across deals. What type of protection? Consider the investor who invested $100 million to get 10% of the company in the example above. That investor's biggest risk is that the value of the business will drop and that investors in subsequent rounds of capital raising or in an initial public offering will be able to get much better deals for their investments. To protect against this loss, the investor may seek (and get) a provision that allows his or her ownership stake to be adjusted for the lower value. With full protection, for instance, if the value of the business drops to $500 million on a subsequent capital event, the original investor's ownership stake will be adjusted up to 20% (reflecting the lower value). This is termed a full ratchet. Alternatively, in the weighted-average approach, the original investor will receive partial protection, resulting in an ownership stake between 10% and 20% if the value drops to $500 million, depending on how the weighted average ownership stake is computed. The key, though, is that this provision is protection against a value drop, but only if the company seeks out capital, and is thus contingent on a capital event occurring.

The protection is usually stated in terms of price per share, where the price per share of the investor's original investment is adjusted to reflect the price per share in the new round of capital, but it is effectively a protection of your original dollar investment and it is easiest to think of this protection as a put option on your investment. In the full ratchet case, assuming a capital event occurs, you are effectively protecting your initial dollar investment, at least until the value of the business hits $100 million (at which point you would be entitled to 100% of the business). Once the value of the business drops below $100 million, the protection can no longer be complete and the pay off diagram for this investment, as a function of the value of the business, is below:

Note that the protection works fully when the value of the business is between $100 million and $ 1 billion and only if there is a capital event to trigger it. To value this option, you need three more pieces of information:

1. Probability of capital event: Since a capital event is the trigger for the protection, there will be no protection if no capital event occurs, a scenario that will unfold if the business unravels quickly. Put differently, the protection is useless if the business never raises any additional capital. (Since the probability of accessing new capital will decrease as the value of the business drops, especially if the drop occurs quickly, the option value is likely to be overstated.
2. Expected time to capital event: The timing of the capital event may not be known with certainty, but to the extent that it can be forecast, you need an expected value. If the protection covers multiple capital events, it is the expected time to the last one.
3. Degree of protection: Depending on how it is structured, the protection offered an investor can range from 100% (with full protection) of the dollar capital invested to less (with weighted average).

Assume, for instance, that the investor in the example above (who invested $100 million for 10% of the business) if offered complete protection in an anticipated IPO of the company and assume further that there is a 90% chance of the IPO occurring in one year. For the standard deviation, I used the industry average standard deviation of 72.48%, derived from publicly traded stocks in the online software business. The expected value (allowing for the 90% chance of a capital event) that I estimate for the protection option, in this spreadsheet, is $25.116 million and the effects on the pre-money and post money valuations are captured below:

• Unadjusted value of protection = Value of put option = $27.98 million
• Value of protection = Value of put option * Probability of capital event = $27.98 * 0.90 = $25.116 million
• Investment made = Capital injected - Value of protection = $100 mil - $25.116 mil = $74.884 mil
• Ownership stake received = 10%
• Post-money valuation = Investment made/Ownership Stake = $ 74.884/.10 = $748.84 million
• Pre-money valuation = Pre-money valuation - Capital Infused = $748.84 - $100 million = $648.84 million

Thus, the capital increase pushed up the value by $100 million and the investor protection clause served to inflate the unadjusted post-money valuation from $748.84 million to $ 1 billion. The greater the investor protection offered and the larger the amount of capital raised, the greater will be the disparity between the true value of the business and its perceived value (based on the transaction details). In the table below, I list out the percentage difference between the true value and the perceived value as a function of investor protection and business risk (captured in standard deviation).

For a $100 million investment for 10% of a company, with a 90% chance of a capital event.

Thus, if investors get 95% protection in a business where equity values have an annualized standard deviation of 70%, the true value of the business will be 21.54% lower than the perceived value (which is $ 1 billion, based on the $100 million investment for 10% of the firm).

I know that I have simplified the complex world of venture capital deal-making in this example, and that allowing for more sophisticated protection mechanisms and multiple capital rounds will make it more difficult to estimate the protection value. However, this example delivers the general message that the more protections that are offered to investors at the time that they invest in young start-ups, the less dependable are the simple extrapolations of value (from capital invested and ownership stakes received).

In my last post, I looked at the determinants of country risk and attempts to measure that risk, by risk measurement services, ratings agencies and by markets. In this post, I would first like to focus on how investors and business people can incorporate that risk into their decision-making. In the process, I will argue that while it is easy to show that risk varies across countries, significant questions remain on how best to deal with that risk when making investment and valuation judgments.

Valuing Country Risk

If the value of an asset is the risk-adjusted present value of its expected cash flows, it stands to reason that cash flow claims in riskier countries should be worth less than otherwise cash flow claims in safer parts of the world. This common-sense principle, though, can be complicated in practice, because there are two ways in which country risk can flow through into value.

1. Adjust expected cash flows: The first is to adjust the expected cash flows for the risk, bringing in the probability of an adverse event occurring and computing the resulting effect on cash flows. In effect, the expected cash flows on an investment will be lower in riskier countries than an otherwise similar investment in safer countries, though the mechanics of how we lower the cash flows has to be made explicit.
2. Modify required return: The second is to augment the required return on your investment to reflect additional country risk. Thus, the discount rate you use for cash flows from an investment in Argentina will be higher than the discount rate that you use for cash flows in Germany, even if you compute the discount rate in the same currency (US dollars or Euros, for instance). The question of whether there should be an additional premium for exchange rate risk is surprisingly difficult to answer, though I will give it my best shot later in this post.

While both processes are used by analysts, the adjustments made to cash flows and discount rates are often arbitrary and risk is all too often double counted. The questions of which types of risks to bring into the expected cash flows and which ones into discount rates but also how to do so remain open and I will lay out my perspective in this post.

Adjust Cash Flows

If there is a probability that your business can be adversely impacted by risk in a country, it stands to reason that you should incorporate this effect into your expected cash flow. There are three ways that you can make this adjustment.

1. Probabilistic adjustment: The first is to estimate the likelihood that a risky event will occur, the consequences for value and cash flow if it does and to compute an expected value. This is the best route to follow for discrete, country-specific risks that can have large or catastrophic effects on your business value, since discount rates don't lend themselves easily to discrete risk adjustment and the fact that the risk is country-specific suggests that globally diversified investors may be able to diversify away some or much of the risk. A good example would be nationalization risk in a country prone to expropriating private businesses, where bringing in its likelihood will lower expected earnings in future periods and cash flows.
2. Build in the cost of protection: The second approach is to estimate the cost of buying protection against the country risk in question and bring in that cost into your expected cash flows. Thus, if you could buy insurance against nationalization, you could reduce your expected earnings by that insurance cost and use those earnings as a basis for estimating cash flows. This approach is best suited to those risks that can be insured against either in the insurance or financial markets. It is also my preferred approach in dealing with corruption risk, which, as I have argued in a prior post, is more akin to an unofficial tax imposed on the company.
3. Cash flow hair cuts: The third way to adjust for country risk is to lower expected cash flows in risky countries 10%, 20% or more, with the adjustment varying across countries (with bigger hair cuts for riskier countries) and analysts (with more risk averse analysts making larger cuts). The perils of this approach are numerous. The first is that it is not only arbitrary but it is also specific to the individual making it, causing it to vary from investment decision to decision and from analyst to analyst. The second is that, once made, the adjustment is hidden or implicit and subsequent decision makers may not be aware that it has already been made, resulting in multiple risk adjustments at different levels of the decision-making process.

A key distinction between the first approach (probabilistic) and the other two (building in cost of insuring risk or haircutting cash flows) is that taking into account the probability that your business could be adversely impacted by an event and adjusting the expected cash flows for the impact does not "risk adjust" the cash flows. You will attach the same value to a risky business as you would to a safe business with the same expected cash flows.

Adjust Required Returns

The second approach to dealing with country risk is to adjust discount rates, pushing up the required returns (and discount rates) for investments made in riskier countries. Those higher rates will push down value, thus accomplishing the same end result as lowering expected cash flows.

Fixed Cash Flow Claims (Fixed Income)

With fixed income claims (bonds, financial guarantees), this is easy enough to do, requiring an additional default spread (for country risk) in the desired interest rate, which, in turn, will lower value. In my last post on country risk, I looked at measures of sovereign default risk including sovereign ratings and credit default swaps. If you have a fixed cash flow claim against a sovereign, you could use these default risk measures to calculate the value of these claims. Thus, if the sovereign CDS spread for Brazil is 2.91% and the risk free rate in US dollars is 2.47%, you would price Brazilian dollar denominated bonds or fixed obligations to earn you 5.38%.

But what if your claim is against a company or business in a risky country? There are two ways in which you could estimate the default spread that you would use to value this claim:

1. Company Rating: Just as ratings agencies and CDS markets estimate default risk in sovereigns, they also estimate default risk in some companies, especially larger ones. If your fixed cash flow claim is against a company where one or both of these are available, you can use them to compute an expected return (and discount your fixed claims at that rate). To illustrate, Vale, a Brazilian mining company, has a bond rating of Baa2 from Moody's in July 2015, and the default spread for a Baa2 rated bond rated bond is 1.75%. Since ratings agencies already incorporate (at least in theory) the fact that Vale is a Brazilian company into the bond rating, there is no need to consider country risk.

US dollar cost of debt for Vale = US $ Risk free rate + Default Spread based on rating = 2.25%+1.75% = 4.00%

2. Country Default Spread + Company Default Spread: For many companies in emerging markets, the first approach will be a non-starter, and for these companies, you will have to approach the cost of debt estimation in two steps. In the first step, you will have to assess the default risk of the company, using its financial statements; I use an interest coverage ratio to estimate a synthetic bond rating and a default spread. In the second, you have to estimate the default spread for the country in which the company is incorporated. For smaller companies that have no way of avoiding the country risk, the US dollar cost of debt becomes:

US dollar cost of debt for company = Risk free rate + Company Default Spread + Country Default Spread

To illustrate, I estimated a synthetic rating of AAA for Bajaj Auto, an Indian auto manufacturer. To get Bajaj Auto's cost of debt in US dollars, I would add the default spread based on this rating (0.40%) and the default spread for India (2.20%) to the US dollar risk free rate (2.25%), yielding a composite value of 4.65%. For larger companies with some or a great deal of global exposure, it is possible that only a portion of the country default spread will apply.

Residual Cash Flow Claims (Equity)

When valuing equity claims, the process of adjusting for country risk becomes more complicated. First, since equity claim holders don't get paid until the fixed cash flow claims have been met, they face more risk and should demand higher rewards for bearing that risk. Second, since equity investors can diversify away some risks, it is possible for a global investor to be exposed to these risks at the country level and still not demand a higher required return for these risks. Thus, if you are augmenting your required returns for country risk, you are arguing that some country risk is not diversifiable to the investors pricing the company exposed to that risk either because they don't have the capacity to diversify away that risk (by holding a globally diversified portfolio) or because there is correlation across countries that results in even globally diversified portfolios continuing to be exposed to country risk. Third, a multinational company is exposed to risky in many countries and not just to the risk of the country in which it is incorporated. Consequently, you have to separate the estimating of risk premiums for countries from that of risk premiums for companies.

Equity Risk Premiums

In earlier posts on this topic, I describe the process by which I estimate equity risk premiums for countries. Briefly summarizing, I start with a premium that I estimate for the S&P 500 at the start of every month as my "mature market premium" and add to that premium an additional country risk premium for riskier countries. I use either the sovereign rating or CDS spread as my measure of country risk, treating all countries with ratings of Aaa (AAA) or sovereign CDS spreads close to the US CDS spread as mature markets and estimating the equity risk premium for other markets as follows:

To illustrate, my estimate of the equity risk premium for the S&P 500 at the start of July 2015 was 5.81%, and my estimate of the equity risk premium for Brazil (with its Baa2 sovereign rating and 1.90% default spread at the start of July) is 8.82%:

The standard deviations of the Bovespa (20.25%) and the Brazilian government bond (12.76%) are used to scale up the default spread to yield an equity risk premium of 8.82%.

Using this approach and extrapolating across countries, I obtained updated equity risk premiums for 169 countries in July and the results are contained in this data set. The global picture of equity risk, at least as I see it, is in below:

Company Exposure to Equity Risk

The standard practice in valuation is to look at a company's country of incorporation and assign an equity risk premium to it, based on that choice, a practice that has its roots in simpler times when much or all of most companies' revenues came from domestic markets and where multinationals were the exception, rather than the rule.

That practice is indefensible in today's markets where most companies, including many small firms, derive their revenues from across the globe and often have their production spread over many countries. It makes far more sense to take a weighted average of equity risk premiums across these many markets to get to a company equity risk premium. The equity risk premiums themselves can be weighted on any of the following:

1. Revenues: To the extent that your revenue stream is dependent upon the economic health of the country from which it is derived, you could argue that it is revenue that you should be focusing on.
2. EBITDA or Earnings: Since value is a function of cash flows (and not revenues), you may be inclined to use the EBITDA, by region, to weight equity risk premiums. There are three concerns you should have, though. The first is that many companies don't break down EBITDA, by region, while most break down revenues globally. The second is that accounting judgments come into play when assessing earnings by region, since expenses have to be allocated across regions. Much as we would like to believe that these allocations are driven by economic fundamentals, it is undeniable that tax considerations play a role. Third, unlike revenues which are always positive, the EBITDA for a region can be negative and it is not clear how you deal with negative weights.
3. Assets: If you are an asset-based company (real estate or hospitality), your primary exposure to country risk may be at the asset level, and your most logical basis for computing an equity risk premium is to weight it based on assets. As with earnings, companies are not always forthcoming breaking down assets and even when broken down, the reported values tend to be book values (rather than market values).
4. Production: In some cases, your primary exposure to risk may be to your operations rather than your revenue streams. In other words, if country risk leads you to shut down your factories, refineries or mines, it does not matter where you generate your revenues. Thus, with natural resource companies and companies that require significant infrastructure investments, you may choose to weight based upon where your production is centered. This is rarely reported in full in most company financials, though you may be able to guess, if you are familiar with the company.

To illustrate, Coca Cola, while headquartered in the United States, has revenues across much of the globe and its 2014 annual report breaks revenues down into geographical regions. Using that revenue breakdown with the weighted ERP of each region from the last section, we estimate an equity risk premium of 6.90% for Coca Cola.

Consider Vale, a commodity company, instead. Its revenue breakdown on 2014 is below, with a weighted equity risk premium of 7.39% for the company.

As you can see, Vale is more exposed to Chinese country risk than Brazilian country risk, at least based on revenues. As a commodity company, you could argue that some of Vale's risks come from where its iron ore/mining reserves lie and that the equity risk premium should reflect that at as well. I agree, but Vale is still surprisingly opaque when it comes to the geographical breakdown of its operations.

Bringing it together

Since country risk can take many different forms and the way you should deal with it varies widely depending on that form, the picture below is designed to capture how best (at least from my perspective) to incorporate risk into value.

There are three keys to dealing with country risk.

1. Look at country risk through the eyes of investors in your company: Many businesses, when looking at country risk, tend to look at how exposed they are to the risk, when they should be looking at risk exposure through the eyes of their investors.
2. Make your risk adjustment(s) transparent: Whatever adjustment you make for country risk, it should be transparent. Put differently, if you adjust discount rates for country risk, your country risk adjustment should be visible to others who may look at your valuation. In far too many valuations, the adjustments for country risk are implicit, thus making it impossible for others to understand the adjustments or take issue with them.
3. Do not double count or triple count risk: In a surprisingly large number of valuations, risk is double counted. Thus, it is not uncommon to see government bond rates that are not risk free being used as risk free rates, multiple hair cuts to the same cash flows and the same risk being adjusted for in both the cash flows and discount rate.

One of the key requirements in operating a business globally is understanding how risk varies across countries and incorporating those risk assessments into whether and where you invest your (or your business) money. In these last two posts, I have tried to provide my perspective on both measuring risk differences across countries and how I think this risk should enter your investment decisions. It is true that both posts have avoided the questions of how the market prices these risks and of how currency risk enter the process, which you may view as glaring omissions, I will deal with the pricing question in my next post and look at decoding the currency puzzle in my last one.

Paper to read:
My paper on country risk (July 2015)

Data attachment:
Equity Risk Premium by Country (July 2015)

Spreadsheet:
Company Risk Premium Calculator

In my last two posts, I looked at country risk, starting with an examination of measures of country risk in this one and how to incorporate that risk into value in the following post. In this post, I want to look at an alternative way of dealing with country risk, especially in investing, which is to let the market price of country risk govern decisions.

Pricing Country Risk

If you are not a believer in discounted cash flow valuations, I understand, but you still have to consider differences in country risk in your investing strategies. If you use pricing multiples (PE, Price to Book, EV to EBITDA) to determine how much you will pay for companies, you could assume that the levels of these multiples in a country already incorporate country risk. Thus, you are assuming that the PE ratios (or any other multiple) will be lower in riskier countries than in safer ones.

It is easy to illustrate the impact of risk on any pricing multiple, with a basic discounted cash flow model and simple algebra. To illustrate, note that you can use a stable growth dividend discount model to back into an intrinsic PE:

Dividing both sides of this equation by earnings, we derive an intrinsic PE ratio:

The PE ratio that you should expect to observe in a country will be a function of the efficiency with which firms generate earnings (measured by the payout ratio), the expected growth in these earnings (g) and the risk in these earnings (captured by the cost of equity). Holding the growth and earnings efficiency constant, then, you should expect to see lower PE ratios in countries with higher risk and higher PE ratios in safer countries. You can use the same process to extract the determinants of price to book ratios or enterprise value multiples and you will arrive at the same conclusion.

Equity Multiples

To see how well this pricing paradigm works, I started by looking at PE ratios by country in July 2015. To estimate the PE ratio for a country, I tried three variants. In the first, I compute the PE ratio for each company in the country (where it was computable) and then average across these PE ratios. To the extent that there are small companies with outlandish PE ratios in the sample (and there are many), these ratios will be skewed upwards. In the second, I compute a weighted average PE ratio across companies, with the weights based upon net income. This ratio is less affected by outliers, but it excludes money losing firms (since the PE ratio is not meaningful for these companies). In the third, I add up the market values of equity across all companies in the market and divide by aggregated net income for all companies, including money losing companies, i.e., an aggregated PE ratio. This ratio has the advantage of including all listed firms in a market but big money losing firms will push this measure up. The picture below summarizes differences in PE ratios across the world, with the weighted average PE ratio as the primary measure, but with the all three reported for each country.

As you can see PE ratios are noisy, with some very risky countries (like Venezuela) trading at high PE ratios and safe countries at lower values, not surprising given how much earnings can shift from year to year. For the most part, the riskiest countries are the ones where stocks trade at the lowest multiple of earnings.

To get a more stable measure of pricing, I computed price to book values by country, again using the simple and weighted averages across companies and aggregated values and report the weighted average Price to Book in the picture below:

As with PE ratios, there are outliers and Venezuela still stands out with an absurdly high price to book ratio, incongruous given the risk in that country. For the most part, though, the PBV ratio is correlated with country risk, as you can see in this list of the 28 countries that have price to book ratios that are less than one in July 2015:

Enterprise Value Multiples

Both PE and PBV ratios are equity multiples and may reflect not just country risk but also variations in financial leverage across countries. To remedy this problem, I look at EV to EBITDA multiples across countries:

Looking at this map, it is quite clear that there is much less correlation between EV/EBITDA multiples and country risk than there is with the equity multiples. While it is true that the lowest EV/EBITDA multiples are found in the riskiest parts of the world (Russia & Eastern Europe, parts of Latin America and Africa), the highest EV/EBITDA multiples are in India and China.

There are two ways of looking at these results. The optimistic take is that if you have to pick a multiple to use compare companies that are listed in different markets, you should use an enterprise value multiple, since it is less affected by country risk. The pessimistic take is that you are likely to over value emerging market companies, if you use EV/EBITDA multiples, since they are less likely to incorporate country risk.

Using these multiples

The standard approach to pricing a company is to choose a multiple and compare how stocks that you deem "comparable" are being priced based on that multiple. This approach can be extended to deal with country risk, albeit with some limitations, in one of four ways:

1. Compare how stocks listed in a country are priced to find "bargains": You could compare PE ratios across Brazilian companies on the assumption that Brazilian country risk is already incorporated in the pricing and buy (sell) the lowest (highest) PE stocks. The danger with this approach is that you are assuming that all Brazilian companies are equally exposed to Brazilian country risk.
2. Compare how stocks within a sector in a country are priced: Rather than compare across all stocks in a market, you could compare stocks within a sector in that market, on the assumption that both country and sector risk are already in the prices. Thus, you could compare the EV/Sales ratios of Brazilian retailers and argue that the retailers that trade at the lowest multiples of revenues are cheapest. The downside is that you may not find enough companies in a country, especially in a smaller market.
3. Compare how stocks within a sector are priced globally: A logical outgrowth of globalization is to compare companies within a sector, even if they are listed in different countries. Thus, you could compare Vale to other mining companies listed globally and Coca Cola to beverage companies across countries. The benefit is that you have more comparable firms but the danger is that you are ignoring country risk.
4. Compare stocks within a sector are priced globally, but control for country risk: In this last approach, you look at the pricing of companies across a sector but try to control for country risk by looking at differences between how the market is pricing companies in developed markets and emerging markets.

No matter which approach you use, you have the pluses and minuses of pricing. The plus is that you will always be able to find "cheap" stocks, because you are making relative judgments and it is simple to get the data. The minus is that if stocks are collectively over priced, either at a country or sector level, a pricing comparison will just yield the least over priced stock in the country or sector.

Valuing and Pricing: Final Thoughts

In my last post, I looked at ways in which you can try to incorporate country risk into the values of companies. In this one, I looked at how price these companies, based upon how the market is pricing other companies in risky countries. As I have argued in my posts on price versus value, the two approaches can yield divergent numbers and conclusions. Thus, you could value a company with all its operations in China, using an appropriate equity risk premium for China, and conclude that the stock is over valued. You could then compare the PE ratio for the same company to the PE ratio for the Chinese market and decide that it is cheap, because it trades at a lower multiple of earnings than a typical Chinese company.

I tend to go with the first approach, since I have more faith in my valuation abilities than in my pricing abilities, i.e., I am more investor than trader. However, I am not quick to dismiss those who use pricing metrics to pick investments, since a nimble trader can play the pricing game very profitably. If you are unsure about where you fall in this process, I would suggest that you both value and price companies and buy only when both signal that the stock is a bargain.

Paper to read:
My paper on country risk (July 2015)

Data attachment:
Equity and EV Multiples by Country: July 2015

In my last three posts, I have looked at country risk, starting with measures of that risk and then moving on to valuing and pricing that risk. You may find it strange that I have not mentioned currency risk in any of these posts on country risk, but in this one, I hope to finish this series by looking first at how currency choices affect value and then at the dynamics of currency risk.

Currency Consistency

A fundamental tenet in valuation is that you have to match the currency in which you estimate your cash flows with the currency that you estimate the discount rate that you use to discount those cash flows. Stripped down to basics, the only reason that the currency in which you choose to do your analysis matters is that different currencies have different expected inflation rates embedded in them. Those differences in expected inflation affect both our estimates of expected cash flows and discount rates. When working with a high inflation currency, we should therefore expect to see higher discount rates and higher cash flows and with a lower inflation currency, both discount rates and cash flows will be lower. In fact, we could choose to remove inflation entirely out of the process by using real cash flows and a real discount rate.

Currencies and Discount Rates

There are two ways in which you can incorporate the expected inflation in a currency into the discount rate that you estimate in that currency. The first is through the risk free rate that you use for the currency, since higher expected inflation should result in a higher risk free rate. The second is by converting the discount rate that you estimate in a base currency into a discount rate in an alternate currency, using the differential inflation between the currencies.

a. Risk free rate

A risk free rate is more than just a number that you look up to estimate discount rates. In a functioning market, investors should set the risk free rate in a currency high enough to cover not only expected inflation in that currency but also to earn a sufficient real interest rate to compensate for deferring consumption.

Risk free rate in a currency = Expected inflation in that currency + Real interest rate

The risk free rate should therefore be higher in a high-inflation currency than using that higher rate should bring inflation into your discount rate.

But how do we get risk free rates in different currencies? While most textbooks would suggest using the rate on a government bond, denominated in the currency in question, that presumes that governments are default free and that the government bond rate is a market-determined rate. However, governments are not always default free (even with local currency borrowings) and the rate may not be market-set. In July 2015, I started with the government bond rates in 42 currencies and cleansed them of default risk by subtracting out the sovereign default spreads (based on local currency sovereign ratings) from them to arrive at risk free rates in these currencies, which you can find in the table below:

Note that the default spread is set to zero for all Aaa rated governments, and the government bond rate becomes the risk free rate in the currency. Thus, the risk free rates in US dollars is 2.47% and in Swiss Francs is 0.16%. To compute the risk free rate in $R (Brazilian Reais), I subtract out my estimate of the default spread for Brazil (1.90%, based on its Baa2 rating) from the government bond rate of 12.58% to arrive at a risk free rate of 10.68%. To estimate a cost of equity in nominal $R for an average risk company with all of its operations in Brazil, you would use the 10.68% risk free rate in $R and the equity risk premium of 8.82% that I reported in my last post to arrive at a cost of equity of 19.50% in $R. That number would be higher for above-average risk companies, with a beta operating as your scaling mechanism.

b. Differential inflation

There are two problems with the risk free rate approach. The first is that it not only requires that you be able to find a government bond rate in the currency that you are working with, but also that the rate be a market-determined number. It remains true that in much of the world, government bond rates are either artificially set by governments or actively manipulated to yield unrealistic values. The second is that you are adding equity risk premiums that are computed in dollar-based markets (since the default spreads that they are built upon are from dollar-based bond or CDS markets) to risk free rates in other currencies. You could legitimately argue that the equity risk premium that you add on to a $R risk free rate of 10.68% should be higher than the 8.82% that you added to a US $ riskfree rate of 2.25% in July 2015.

If the differences between currencies lies in the fact that there are different expectations of inflation embedded in them, you should be able to use that differential inflation to adjust discount rates in one currency to another. Thus, if the cost of capital is computed in US dollars and you intend to convert it into a nominal $R cost of capital, you could do so with the following equation:

To illustrate, if you assume that the expected inflation rate in $R is 9.5% and in US $ is 1.5%, you could compute the cost of equity in US$ and then adjust for the differential inflation to arrive at a cost of equity in $R:
Cost of equity for average risk Brazilian company in US $ = 2.25% + 8.66% = 10.91%

The cost of equity of 19.65% that we derive from this approach is higher than the 19.50% that we obtained from the risk free rate approach and is perhaps a better measure of cost of equity in $R.

This approach rests on being able to estimate expected inflation in different currencies, a task that is easier in some than others. For instance, getting an expected inflation rate in US dollars is simple, since you can use the difference between the 10-year T.Bond rate and the TIPs (inflation-indexed) 10-year bond rate as a proxy. In other currencies, it can be more difficult, and you often only have past inflation rates to go with, numbers that are prone to government meddling and imperfect measurement mechanisms. Notwithstanding these problems, I report inflation rates in different countries, using the average inflation rate from 2010-2014 for each country.

I also report the inflation rate in 2014 and the IMF expectations for inflation (though I remain dubious about their quality) for each country.

Currencies and Cash Flows

Following the currency consistency principle is often easier with discount rates, where your inflation assumptions are generally either explicit or easily monitored, than it is with cash flows, where these same assumptions are implicit or borrowed from others. If you add in accounting efforts to adjust for inflation and inconsistencies in dealing with it to the mix, it should come as no surprise that in many valuations, it is not clear what inflation rate is embedded in the cash flows.

a. Inflation in your growth rates

In most valuations, you start with base year accounting numbers on revenues, earnings and cash flows and then attach growth rates to one or more of these numbers to get to expected cash flows in the future. At the risk of stating the obvious, the expected inflation rate embedded in this growth rate has to be the same inflation rate that you are incorporating in your discount rate. This simple proposition is put to the test, though, by the ways in which we estimate these expected growth rates, which is to use history, trust management/analyst projections for the future or base it on fundamentals (how much the company is reinvesting and how well it is reinvesting):

1. Past Growth: With historical growth, where you estimate growth by looking at the past, your biggest exposure to mismatches occur in currencies where inflation rates have shifted significantly over time. For instance, assume that you are valuing your company in Indian rupees in July 2015 and that the average inflation rate in India, which was 8% between 2010 and 2014 is expected to decline to 4% in the future. If you use historical growth rates in earnings, between 2010 and 2014, for an Indian company, you are likely to over value the company because its past growth rate will reflect past inflation (8%) but your discount rates, computed using expected inflation or current risk free rates in rupees, will reflect a much lower inflation rate.
2. Management/Analyst Forecasts: With management or analyst forecasts, the problem is a different one, since the expected inflation rates that individuals use in their forecasts can vary widely. While there is no reason to believe that your estimate of expected inflation is better than theirs, it is undeniably inconsistent to use management estimates of expected inflation for growth rates and your own or the market's estimates of inflation, when estimating discount rates.
3. Fundamental or Sustainable Growth: I believe that the best way to keep your valuations internally consistent is to tie growth to how much a company is reinvesting and how well it is reinvesting. The measures we use to measure reinvestment and the quality of investment are accounting numbers and inflation mismatches can enter insidiously into valuations. Assume, for instance, that you are estimating reinvestment rates and returns on capital for a Brazilian company, using its Brazilian financial statements. Since Brazilian accounting allows for inflation adjustments to assets, the return on capital that you compute is closer to a real return on capital (with no or low inflation embedded in it) than to a nominal $R return on capital, if inflation accounting works as advertised. In countries like the United States, where assets are not adjusted for inflation, you can argue that the return on capital is a nominal number, but one that reflects past inflation, not expected future inflation. In either case, the growth rate that you compute from these numbers will be skewed.

b. Expected Exchange Rates

It is common practice, in some valuation practices, to forecast cash flows in a base currency (even if it is not the currency that you plan to use to estimate your discount rate) and then convert into your desired currency, using expected exchange rates. Thus, a Brazilian analyst who wants to value a Brazilian company in US dollars may estimate expected cash flows in nominal $R first and then convert these cash flow into US $, using an $R/US $ exchange rate. The big estimation question then becomes how best to estimate expected exchange rates and there are three choices.

1. Use the currency exchange rate: The first one, especially in the absence of futures or forward markets, is to use the current exchange rate to convert all future cash flows. This will result in an erroneous value for a simple reason: it creates an inflation mismatch. If, for instance, the expected inflation rate in $R in 9.5% and in US$ is 1.5%, you will significantly over value your company with this approach, because you have effectively built into a 9.5% inflation rate into your cash flows (by using a constant exchange rate) and a 1.5% inflation rate into your discount rate (since you are estimating it in US dollars).
2. Use futures and forward market exchange rates: This is more defensible but only if you then extract risk free rates from these same futures/forward market prices. (This will require that you assume interest rate parity in exchange rates and derive the interest rate in $R from the $R/US$ forward rate). In addition, in many emerging market currencies, the forward and futures markets tend to be operational only at the short end of the maturity spectrum, i.e., you can get 1-year forward rates but not 10-year rates.
3. Use purchasing power parity: With purchasing power parity, the expected exchange rates are driven by differential inflation in the currencies in question. Thus, if purchasing power parity holds and the inflation rates are 9.5% in $R and 1.5% in US$, the $R will depreciate roughly 8% every year. While I am sure that you can find substantial evidence of deviation from purchasing power parity for short or even extended periods, here is why I continue to stick with it in valuation. By bringing in the differential inflation into both your cash flows and the discount rate, it cancels out its effect and thus makes it less critical that you get the inflation numbers right. Put differently, you can under or over estimate inflation in $R (or US $) and it will have no effect on your value.

Currencies and Value

If you can make it through the minefields to estimate cash flows and discount rates consistently, i.e., have the same expected inflation rate in both inputs, the value of a company or a capital investment should be currency invariant. In other words, if you value Tata Motors in Indian rupees, you should get the same value for the company, if you value it entirely in US dollars. If you don't get the same value, I would argue that the difference comes from one or two sources:

• Inflation inconsistencies: It is stemming from inconsistencies in the way that you have dealt with inflation in different currencies, since a company's value should come from its fundamentals and not from which currency you chose to evaluate it in.
• Currency views: You have built in a currency view into your company valuation. Thus, if you assume that the $R will strengthen against the US dollar in the next 5 years, when estimating cash flows, notwithstanding the higher inflation rate, you will find your company to be under valued, when you value it in $R. If that is the case, my suggestion to you would be to just buy currency futures or options, since you are making a bet on the currency, not the company.

The bottom line is that your currency choice should neither make nor break your valuation. A well-run company that takes good investments should stay valuable, whether I value it in US dollars, Euros, Yen or Rubles, just as a badly run or risky company will have a low value, no matter what currency I value it in.

Currency Risk

When working with cash flows in a foreign currency, it is understandable that analysts worry about currency risk, though their measurement of and prescriptions for that risk are often misplaced. First, it is not the fact that exchange rates change over time that creates risk, it is that they change in unexpected ways. Thus, if the Brazilian Reai depreciates over the next five years in line with the expectations, based upon differential inflation, there is no risk, but if it depreciates less or more, that is risk. Second, even allowing for the fact that there is currency risk in investments in foreign markets, it is not clear that analysts should be adjusting value for that risk, especially if exchange rate risk is diversifiable to investors in the companies making these investments. If this is the case, you are best served forecasting expected cash flows (using expected exchange rates) and not adjusting discount rates for additional currency risk.

It is true that currency and country risk tend to be correlated and that countries with high country risk also tend to have the most volatile currencies. If so, the discount rates will be higher for investments in these countries but that augmentation is attributable to the country risk, not currency risk.

Currency Rules for the Road

It is easy to get entangled in the web of currency effects and lose sight of your quest for value, but here are few rules that I think may help you avoid distractions.

1. Currencies are measurement mechanisms, not value drivers: As I write this post, it is a hot day in New York, with temperatures hitting 95 degrees in fahrenheit. Restating that temperature as 35 degrees celsius may make it seem cooler (it is after all a lower number) but does not alter the reality that I will be sweating the minute that I step out of my office. In the same vein, if I value an Argentine company in a risky business, converting its cash flows from Argentine pesos to US dollars will not make it less risky or less exposed to Argentine country risk.
2. Pick a currency and stick with it: The good news is that if your valuations are currency invariant, all you have to do is pick one currency (preferably one that you are comfortable with) and stick with it through your entire analysis.
3. Make your inflation assumptions explicit: While this may cost you some time and effort along the way, it is best to be explicit about what inflation you are assuming, especially when you estimate cash flows or exchange rates, to make sure that it matches the inflation assumptions that you may be building into your discount rates,
4. Separate your currency views from your company valuations: It is perfectly reasonable to have views on currency movements in the future but you should separate your currency views from your company valuations. If you do not, it will be impossible for those using your valuations to determine whether your judgments about valuation are based upon what you think about the company or what you feel about the currency. It is this separation argument that is my rationale for sticking with much maligned purchasing power parity in estimating future exchange rates.
5. You can run, but you cannot hide: If inflation is high and volatile in your local currency, it is easy to see why you may prefer working with a different, more stable currency. It is the reason why so much valuation and investment analysis in Latin America was done in US dollars. The bad news, though, is that while switching to US dollars may help you avoid dealing with inflation in your discount rate, you will have to deal with it in your cash flows (where you will be called upon to forecast exchange rates).

Paper to read:
My paper on country risk (July 2015)

Data attachment:
1. Risk free rates in different currencies (July 2015)
2. Inflation rates, by country (July 2015)

Pearson PLC, the British publishing/education company, has been busy this summer, shedding itself of its ownership in two iconic media investments, the Financial Times and the Economist. On July 23, 2015, it sold its stake in the Financial Times for $1.3 billion to Nikkei, the Japanese media company, after flirting with Bloomberg, Reuters and Axel Springer. It followed up by selling its 50% stake in the Economist for $738 million, with 38% going to Exor, the investment vehicle for the Agnelli family, and the remaining 12% being purchased by the Economist Group itself.

The motive for the divestitures seems to be a desire on the part of Pearson to stay focused on the education business but what caught my eye was the description of both the Financial Times and the Economist as "trophy" assets, a characterization that almost invariably accompanies an inability on the part of analysts to explain the prices paid by the acquirer, with conventional business metrics (earnings, cash flows, revenues etc.).

What is a trophy asset?

My first task in this analysis was to find other cases where the term was used and I found that its use spreads across asset classes. For instance, it seems to be commonplace in real estate transactions like this one, where high-profile properties are being acquired. As in the stories about the Economist and the Financial times, it seems to also be used in the context of media properties that have a long and storied tradition, like the Washington Post and the Boston Globe. In the last few years, sports franchises have increasingly made the list as well, as billionaires bid up their prices for these franchises. I have seen it used in the context of natural resources, with some mines and reserves being categorized as trophy assets for mining companies. While this is a diverse list, here are some of what they share in common:

1. They are unique or rare: The rarity can be the result of natural scarcity (mining resources or an island in Hawaii), history (a newspaper that has survived a hundred years) or regulation/restriction (professional sports leagues restrict the creation of new franchises).
2. They have name recognition: For the most part, trophy assets have name recognition that they acquire either because they have been around for a long time, are in the news or have wide following.
3. They are cash flow generating businesses or investments: In contrast with collectibles and fine art, trophy assets are generally cash flow generating and can be valued as conventional assets/businesses.

There is undoubtedly both a subjective and a negative component to the "trophy asset" label. The subjective component lies in how "rare" is defined, since some seem to define it more stringently than others. The negative aspect of labeling an asset as a trophy asset is that the buyer is perceived as paying a premium for the asset. Thus, an asset is more likely to be labeled as a trophy asset, when the buyer is a wealthy individual, driven more by ego and less by business reasons in making that investment.

Valuing a trophy asset

Rather than take it as a given that buyers overpay for trophy assets, let us look at the possibility that these assets are being acquired for their value rather than their glamor. We have the full financial statements for the Economist but only partial estimates for the Financial Times, and I have used this information to estimate base values for the two assets:

Thus, based on the earnings power in the two assets and low growth rates, reflecting their recent static history, the estimated value for the Economist is about PS800 million and the Financial Times is worth PS410 million. I will label these values in this table as the status quo estimates, since they reflect the ways in these media names are managed currently. While you could take issue with some of my assumptions about both properties, it seems to me that Nikkei's acquisition price (PS844 million) for the Financial Times represents a much larger premium over value than Exor's acquisition of the Economist Group for PS952 million. Does that imply that Nikkei is paying a trophy asset premium for the Financial Times? Perhaps, but there are three other value possibilities that have to be considered.

1. Inefficiently utilized: If a trophy asset is under utilized or inefficiently run, a buyer who can use the asset to its full potential will pay a premium over the value estimated using status quo numbers. That is difficult to see in the acquisition of the Economist stake, at least to the Agnellis, since the interest is a non-controlling one (with voting rights restricted to 20%), suggesting that the acquirer of the stake cannot change the way the Economist is run. With the Financial Times, the possibilities are greater, since there are some who believe that the Pearson Group has not invested as much as it could have to increase the paper's US presence.
2. Synergy benefits to another business: If the buyer of the trophy asset is another business, it is possible that the trophy asset can be utilized to increase cash flows and value at the acquiring business. The value of those incremental cash flows, which can be labeled synergy, can be the basis for a premium over the status quo value. With the Nikkei acquisition of the Financial Times, this is a possibility, especially if growth in Asia is being targeted. With the Agnelli acquisition of the Economist, it is difficult to see this as a rationale since Exor is an investment holding company, not an operating business.
3. Optionality: There is a third possibility and it relates to other aspects of the business that currently may not be generating earnings but could, if technology or markets change. With both the Economist and the Financial Times, the digital versions of the publications in conjunction with large, rich and loyal reader bases offer tantalizing possibilities for future revenues. That option value may justify paying a premium over intrinsic value. In fact, at the risk of playing the pricing game, note that you are acquiring the Economist at roughly the same price that investors paid for Buzzfeed, a purely digital property with a fraction of its history and content.

With the Financial Times, adding these factors into the equation reinforces the point that the price paid by Nikkei can be justified with conventional value measures. With the Economist, and especially with the Exor acquisition, it does look like the buyers are paying a premium over value.

Pricing a trophy asset

As many of you who read my blog know, I have a fetish when it comes to differentiating between the value of an asset and its price. If value is a function of the cash flows from, growth in and risk of a business (estimated using intrinsic valuation models), price is determined by demand and supply and driven often by mood and momentum. If "trophy assets" are sought after by buyers just because they are rare and have name recognition, it is entirely possible that the pricing process can yield a number (price) very different from that delivered by the value process. In particular, the more sought after the trophy asset, the greater will be the premium that buyers are willing to pay (price) over value.

In June 2014, when Steve Ballmer bid $2 billion to buy the Los Angeles Clippers, I tried first explaining his bid by valuing the Clippers as a business. Even my most optimistic estimates of earnings and cash flows at the franchise generated a value of $1.2 billion for the franchise, leading me to conclude that Ballmer was paying the excess amount ($800 million) for an expensive play toy. While it is possible that the same motivations may be driving John Elkann, the scion of the Agnelli family and chairs Exor, in his acquisition of the Economist, I hope that Nikkei, a privately held business, is not paying for an expensive toy.

I am not arguing that paying this price premium is irrational or foolish. Far from it! First, it is possible that the emotional dividends that you receive from owning a trophy asset make up for the higher price up front. After all, Steve Ballmer's friends are likely to be much more excited about being invited to have a ring side view of a Clippers game than watch Microsoft introduce Windows 10. Second, paying a premium over value does not preclude you from generating nosebleed returns from your investment, if you can find other buyers who are willing to pay even bigger premiums to take these trophy assets of your hands. In fact, many sports franchise buyers in the last decade who were viewed as paying nosebleed prices for their acquisitions have been able to sell them to new buyers for even higher prices.

Implications

I tend to be skeptical of when an assets is casually labeled as a trophy asset, since it the labeling allows us to categorize its buyers as driven by non-financial considerations, without having to back up that contention. While both the Economist and the Financial Times have been labeled trophy assets, I think we have to hold back on that judgment, especially with the latter, to see what Nikkei has in mind for its new addition. After all, people were quick to label the acquisition of the Washington Post by Jeff Bezos as a trophy buy, but news stories suggests that there have been major changes at the Post since the deal was completed, which may be laying the foundations for delivering value.

If an asset class becomes a repository for trophy assets, it will attract buyers who will pay for non-economic benefits and the pricing of assets will lose connection to fundamentals. At the MIT Sloan Sports Conference this year, I was on a panel about the "valuation" of sports franchises and I made the argument that wealthy buyers in search of glamorous toys were increasingly changing these markets into pricing markets. In fact, as long as the number of sports franchises is static and the number of billionaires keeps increasing, I see no reason for this trend to stop. So, if the New York Yankees or Real Madrid go on the auction block, be prepared for some jaw-dropping prices for these franchises.

Blog Post Links
Ballmer's Bid for the Clippers: Investment, Trade or Expensive Toy

Spreadsheets
Valuing the Financial Times and the Economist

I have generally steered from using my blog as a vehicle for rants, not because I don't have my share of targets, but because I know that while ranting makes me feel better, it almost always creates more costs than benefits. It is true that I have had tantrums (mini-rants) about the practice of adding back stock-based compensation to EBITDA or expensing R&D to get to earnings, but the targets of those tend to be harmless. After all, what can sell-side Equity Research Analysts or accountants collectively do to retaliate? Refuse to send me their buy and sell recommendations? Threaten me with gang-audits?

This post is an exception, because the target of the rant is China, a much bigger and more powerful adversary than those in my mini-rants, and it is only fair that I let you know my priors before you read this post. First, I am hopelessly biased against the Chinese government. I believe that its reputation for efficiency and economic stewardship is inflated and that its thirst for power and money is soft-pedaled. Second, I know very little about the Chinese economy or its markets, how they operate and what makes them tick. It it true that some of my ignorance stems from the absence of trustworthy information about the economy but a great deal of it comes from not spending any time on the ground in China. So, if you disagree with this post, you have good reason to dismiss it as the rant born of ignorance and bias. If you agree with it, you should be wary for the same reasons.

The Chinese Economic Miracle: Real or Fake?

For the last two decades, the China story has been front and center in global economics, and with good reason. In the graph below, you can see the explosive growth in Chinese GDP, measured in Chinese Yuan and US dollars:

The Chinese economy grew from being the eighth largest in the world in 1994 to the second largest in the world in 2014. It is true that many of the statistics that we use for China come from the Chinese government and there are is reason to question its reliability. In fact, there are some with conspiratorial inclinations who wonder whether the Chinese miracle is a Potemkin village, designed for show. Much as my bias would lead me down this path, there are some realities on the ground that are impossible to ignore:

1. The China growth story is real: Any one who has visited China will tell you that the signs of real growth are around you, especially in urban China. It is not just the physical infrastructure of brand new airports, highways and high-speed trains, but the signs of prosperity among (at least some of) its people. I did my own experiment yesterday that confirmed the reality of Chinese growth. After I woke up to the alarm on my China-made iPhone, I put on my Nike exercise clothes, manufactured in China, slipped on my Asics running shoes, also from China. As I went through the day, it was easier for me to keep track of the things that were not made in China than those that were. Based just on that very unscientific sampling, I am willing to believe that China is the world's manufacturing hub.
2. It has a Beijing puppet-master: To those who celebrate the growth of the Chinese economy as a triumph of free markets, I have to demur. The winners and losers in the Chinese economy are not always its best or most efficient players and investment choices are made by policy makers (or politicians) in Beijing, not by the market. There are those who distrust markets who would view this as good, since markets, at least in their view, are short term, but trusting a group of experts to determine how an economy should evolve can be even more dangerous.
3. It is driven by infrastructure investment, not innovation: The Chinese economy is skilled at copying innovations in other parts of the world, but not particularly imaginative in coming up with its own. It is revealing that the current vision of innovation in China is to have a CEO dress up like Steve Jobs and make an Android phone that looks like the iPhone. Note that this should not be taken as a reflection of the Chinese capacity to be innovative but a direct consequence of centralized policy (see prior point).
4. The China story is now part of every business: In just the last month and a half, I have been in the US, Brazil and India, and can attest to the fact that the China story is now embedded in companies across the globe. In the US, I saw Apple report good earnings and lose $100 billion in market capitalization, with some attributing the drop to disappointing results from China. In Brazil, my Vale valuation rests heavily on how China does in the future, because China accounts for 37% of Vale's revenues and the surge in iron ore prices in the last decade came primarily from Chinese infrastructure investment. In India, I valued Tata Motors, whose acquisition of Jaguar , has made them more of a Chinese company than an Indian one, dependent on the Chinese buying oversized Land Rovers for a significant portion of their profits.
5. It is also a weapon of mass distraction: In a post from a few months ago, I talked about weapons of mass distraction, words that analysts use to induce you to pay premiums for companies and to distract you from specifics. In that post, I highlighted "China" as the ultimate wild card, with mention of exposure to the country operating as an excuse for pushing up the stock price. The problems with wild cards though is that they are unpredictable, and it is entirely possible that the China card may soon become a reason to discount value, as the handwringing about earnings effects and corporate exposures of the China crisis begins.

The Chinese Markets: All Pricing, all the time!

If you have been reading the news for the last few months, which have been about the epic collapse of Chinese stocks, I would not blame you for feeling sorry for investors in the Chinese market. I would suggest that you save your sympathy for more deserving causes, because as with everything else in markets, it depends on your time perspective. In the chart below, I look at three charts that look at the Shanghai Composite over time:

It is undeniable that markets have been melting down since June, with the Shanghai Composite down 32% from its peak on June 12. However, if you had invested in Chinese stock at the start of this year, you have no reason to complain, with a return of 8.44% for the year to date, among the best-performing markets globally. Stepping even further back, if you had invested in Chinese stocks in 2005, you would have earned close to 13$ as an annual return each year, with all the ups and downs in between.

In earlier posts, I have drawn a contrast between valuation and pricing and why a healthy market need both investors (who buy or sell businesses based on their perceptions of the values of these businesses) and traders (who buy and sell assets based on what they think others will pay for them). A market dominated mostly by investors will quickly become illiquid and boring, and ironically reduce the incentives to collect information and value companies. A market dominated by traders will be volatile, with price movements driven by mood, momentum and incremental information, and will be subject to booms and busts. I would characterize the Chinese stock market as a pricing market, where traders rule and investors have long since fled or have been pushed out. While there are some who will attribute this to China being a young financial market, and others to cultural factors, I believe that it is a direct consequence of self-inflicted wounds.

1. Investor restrictions: There is perhaps no more complicated market to trade in than the Chinese markets, with most Chinese companies having multiple classes of shares: Class A shares, and traded primarily on the mainland, denominated in Yuan, Class B shares, denominated in US $, traded on the mainland and Class H shares, traded in Hong Kong, denominated in HK$. The Chinese government imposes tight restrictions on both domestic investors (who can buy and sell class A shares and class B shares, but only if they have legal foreign currency accounts, but cannot trade in class H shares) and foreign investors (who can buy and sell only class B and class H shares). As a consequence of these restrictions, investors are forced into silos, where shares of different classes in the same company can trade at different prices and governments can keep a tight rein on where investors put their money. Note also that the highest profile technology companies in China, like Baidu and Alibaba, create shell entities (variable interest entities or VIEs) and list themselves on the NASDAQ, making them effectively off-limits to domestic investors.
2. Opaque financials and poor corporate governance: While China has moved towards adopting international accounting standards, Chinese companies are not doyens of disclosure, often holding back key information from investors. It is therefore not surprising that almost 10% of all securities class action litigation in the US between 2009 and 2013 was against Chinese companies listed in the US, that variable interest entities hold back key information and that non-Chinese companies like Caterpillar and Lixil have had to write off significant portions of their Chinese investments, as a result of fraud. This non-disclosure problem is twinned with corporate governance concerns at Chinese companies, where shareholders are viewed more as suppliers of capital than as part-owners of the company.
3. Markets as morality plays: The nature of markets is that they go up and down and it is that unpredictability that keeps the balance between investors and traders. In China, the response to up and down markets is asymmetric. Up markets are treated as virtuous and traders who push up stock prices (often based on rumor and greased with leverage) are viewed as "good" investors. Down markets are viewed as an affront to Chinese national interests and not only are there draconian restrictions on bearish investors (restrictions on short selling, trading stops) but investors who sell stock are called traitors, malicious market manipulators or worse. Thus, the same Chinese government that sat on its hands as stock prices surged 60% from January to June has suddenly discovered the dangers of volatility in the last few weeks as markets have given up much of that gain.

The bottom line is that the Chinese government neither understands nor trusts markets, but it needs them and wants to control them. By restricting where investors can put their money, treating short sellers as criminals and market drops as calamities, the Chinese government has created a monster, perhaps the first one that does not respond to its dictates. The current attempt to stop the market collapse, including buying with sovereign funds, putting pressure on portfolio managers, name calling and sloganeering may very well succeed in stopping the bleeding, but the damage has been done.

Moneyball in China

The best cure for bias and ignorance is data and I decided that the first step in ridding myself of my China-phobia would be a look at how Chinese stocks are being priced in the market today. The essence of value investing is that at the right price, any company (including a Chinese company with opaque financials and non-existent corporate governance) can be a good investment and it is possible that the drop in stock prices in the last few months has made Chinese stocks attractive enough for the rest of us.

To make these comparisons, I used the market price data as of August 19, 2015, to estimate market capitalization and enterprise values. For the accounting data, I used the numbers from the trailing 12 months, generally the 12 months ending mid-year 2015, for most companies. The first comparison was on pricing multiples:

I compared China with India, Brazil and Russia, the three other countries that have been lumped together (awkwardly, in my view) as the BRIC, as well as with the rest of the emerging markets. For comparisons, I also looked at the US and the rest of the developed markets (where I included Japan, Western Europe, Australia, Canada and New Zealand). In spite of the drop in stock prices in the last few months, Chinese stocks are collectively more expensive than stocks anywhere else in the world.

To measure the profitability of Chinese companies, I looked at three measures of margin (EBITDA, Operating Income and Net Income) and three measures of return (Return on Equity and Return on Invested Capital):

Chinese companies lag the rest of the world, when it comes to EBITDA and operating margins, but do better than other emerging market companies on net margins. On returns on equity and invested capital, Chinese companies are more profitable than Brazilian companies (reflecting the economic downturn in Brazil in the last year) but are pretty much on par with the rest of the world.

One reason for the superior net margins at Chinese companies is that they tend to borrow less than companies elsewhere in the world, perhaps the only bright light in these comparisons.

That may be at odds with some of what you may be reading about leverage in China, but it looks like the debt in China is either more in the hands of local governments or is off balance sheet.

Finally, if the straw that you are grasping for is higher growth in China, there is some backing for it when you compare growth rates across companies, but only in analyst expectations, rather than in growth delivered:

It is true that this market-level look at China may be missing bargains at the sector level and to remedy that, I looked at PE ratios and EV/EBITDA multiples regionally, by industry grouping. The industry-average values, classified by region, can be downloaded here, but across the ninety five industry groupings, Chinese companies have the highest PE ratios in the world in fifty and the highest EV/EBITDA multiples in fifty eight. You could dig even deeper and look at company-level data and you are welcome to do so, using the complete dataset here.

Overall, I am hard pressed to make a case for investing in Chinese stocks, if you have a choice of investing in other markets, even after the market drop of the last few months. If you are a domestic investor in China, your choices are more restricted, and you may very well be forced to stay in this market. It is interesting that India and China, two markets that restrict domestic investors from investing outside the country, are the two most richly priced.

Conclusion

As I confessed up front, I am not a China hand and don't claim any macro or market forecasting skills, but my experience with company valuation and pricing lead me to make the following predictions for China.

1. Slower real growth: If I were a betting man, I would be willing to take a wager that the expected real growth rate in the Chinese economy will be closer to 5% a year for the next decade than to the double-digit growth that we have been programmed to expect. That may strike you as pessimistic, after the growth of the last two decades, but just as size eventually catches up with companies, the Chinese economy is getting too big to grow at the rates of yesteryear. The question, for me, is not whether this will happen but how the Chinese government will deal with the lower growth. While the sensible option is to accept reality and plan for lower real growth, I fear that the need to maintain appearances will lead to a cooking of the economic books, in which case we will have an number-fixing scandal of monumental proportions.
2. More pricing ahead: I don't see much hope that investors will be welcomed back into Chinese markets any time soon. So, even if this market shakeup drives some of traders out of the game, investors motivated by value will be reluctant to step in, if the government continues to make markets into morality plays. As long as the market continues to be a pricing game, the price moves in the market will have little do with fundamentals. As a consequence, I would suggest that you ignore almost all attempts by market experts to explain what is happening in Chinese markets with economic stories.
3. Buyer beware: If you are drawn to Chinese markets (like moths to a flame), here is my advice for what it is worth. If you are an investor, you need to look past the hype and value companies, opacity and complexity notwithstanding, and be a realist when it comes to corporate governance. If you are a trader, this is a momentum game and if you can get ahead of momentum shifts, you will make money. If your bet is on the downside, just be ready to be maligned, abused or worse.

I understand why corporate chieftains and heads of government are unwilling to speak openly about the Chinese government, given how much of their own economic prosperity rests on maintaining good relations. Financial markets don't have such qualms and they are delivering their message to Beijing clearly and decisively. Let's hope someone is listening!

Attachments
1. Industry-average PE and EV/EBITDA, by sector
2. Chinese Company-level data, Multiples and Fundamentals

It is almost September and as the academic clock resets for a new year, I get ready to teach a new valuation class. With three hundred registered students, it is about as diverse a class as any I have every taught, with a mix of full-time and part-time MBA students, law and engineering graduate students and a few dozen undergraduates. And with a market meltdown framing discussions, it will be interesting to see how the class plays out. As always, I cannot wait for the class to start and as I have, each semester, for the last few years, I invite you to follow the class, if you are so inclined.

Setting the table

Valuation is an intimidating title for a class, stirring up visions (and nightmares) about spreadsheets, accounting statements and financial theory. This may be the default version of the class and it serves experts in the topic well to preserve this air of mystery and intimidation. I have neither the expertise nor the desire to teach such a class, and I hope that you will not only take my class, no matter what your background and experience, but that you will also learn to enjoy valuation as much as I do. The best way for me to start describing my class is to tell you what it is not about, rather than what it covers. So, here we go:

1. It is not an accounting class: Much of the raw data in my valuations comes from accounting statements, but once I get that raw data, I lose interest in the rest of the accounting details. In fact, one of my first in-practice webcasts (short webcasts about practical issues in valuation) uses the Procter and Gamble 10k to illustrate how little of a typical accounting filing gets used in valuation and how much is irrelevant or useless. I admire people who can forecast our full financial statements (income statements, balance sheets and cash flow statements) decades out, but I have never ever felt the urge to do so and I am not sure that I have the accounting skills to even do so.
2. It is not a modeling class: As someone who did his first valuation on an old fashioned columned paper sheet with a calculator, I have mixed feelings about spreadsheets, in general, and Microsoft Excel, in particular. I like the time that I save in computational details, but I have to weigh that against the time I lose, playing pointless what-if games with the data that I would never have considered in my calculator days. I admire Excel Ninjas but I have also seen what happens when analysts become the spreadsheet's tools, rather than the other way around. Needless to say, I have never taught a session (let alone a class) built around Excel spreadsheets, though I have no qualms about using one to illustrate fundamental valuation principles.
3. It is not a financial theory class: To be able to teach this class at a research university, I had to go through the rites of passage of a Finance doctoral student, traversing the path that finance has followed, starting with Harry Markowitz and modern portfolio theory, moving through its Greek phase (with alphas and betas dominating the conversation first and then leading on to the expropriation of the rest of the Greek alphabet by the options theorists) to the counter-revolutionaries of behavioral finance. Unlike some who make you choose whether you are for financial theory or against it, I view it as a buffet, where I can partake on the portions of the theory that I find useful and leave behind that which I do not. In my valuation class, in particular, I would be surprised if I spent more than 5% of my time on financial theory, and if I do, it is only because I am trying to get to some place more interesting.

Now that I have established what the class is about, let me lay out the five themes around which this class is built.

1. Valuation is a craft, not an art or a science: I start my class with a question, "Is valuation an art or a science?", a trick since the answer, in my view, is neither. Unlike physics and mathematics, indisputably sciences with immutable laws, valuation has principles but none that meet the precision threshold of a science. At the other extreme, valuation is not an art, where your creative instincts can guide you to wherever you want to go and geniuses can make up their own rules. I believe that valuation is a craft, akin to cooking and carpentry, and that you learn what works and what does not by doing it, not by reading or listening to others talk about it. That is the reason that each week during the course of the semester, I post my valuation of a company, with a Google shared spreadsheet for everyone in the class to try their hand at valuing the same company and coming to a very different conclusion than I do.
2. Valuing an asset is different from pricing it: I will not bore you by repeating this distinction that I drew first in this post but have returned to over and over again. It is my belief that much of what passes for valuation, in practice, is really pricing, sometimes disguised as valuation and sometimes not, but I also think that there is nothing wrong with pricing an asset, if that is what your job entails. Thus, though the bulk of this class is built around intrinsic value and its determinants, a significant portion of the class is dedicated to better pricing techniques, through the judicious use of multiples, comparable assets and statistics.
3. Anything can be priced and most almost anything can be valued: This may be stubborn side speaking, but I have always believed that you can value any cash-flow generating asset (as I have attempted to, in these posts on valuing tracking stock on a professional athlete, a sports team, a trophy asset and young companies) and that you can price any asset (as I tried to to, in these posts on Gold and Bitcoins). While this class is centered around valuing publicly traded companies, I deviate from that script often enough, that by the end of the class, you should be able to value and price any asset.
4. Valuation = Story + Numbers: As readers of this blog, you have heard me get on the soapbox often enough, but to me the essence of valuation is connecting stories to numbers. As I noted in this most recent post of mine, this requires me to push people out of their comfort zones, encouraging numbers people to tell more stories and stories people to work more with numbers. No matter how far on either end of the numbers/ story spectrum you are, I think that no one is beyond reach.
5. Valuation without action is pointless: I have never felt the need to use a case study in my valuation class or value a widget company in my class, because I not only find valuing real companies in real time more interesting, but I can act on my own valuations and I usually do, though not always with conviction. Investing requires faith in both your capacity to value companies and in markets correcting over time and I try to let people see both the source of my faith and challenges to that faith.

   I did put together a short (about two minutes) YouTube video of my class that summarize my perspective on this class.

So, both number crunchers and story tellers, welcome to the class and we can learn from each other!

Prepping for the class

As a realist, there are a few skills that will stand you in good stead in this class and none of these skills are difficult to acquire.

1. Read financial statements: For better or worse, our raw data comes from accounting statements and you need to be able to navigate your way through these statements. If you have a tough time deciphering the difference between gross, operating and net income, and don't quite understand what goes into book value of equity, you will have a tough time valuing companies. Don't remember your accounting classes? Don't want to go back there? Never fear! I have a primer on accounting that takes you through the absolute basics (which is about all I know anyway) and you can get to it by clicking on this link.
2. Understand basic statistics: Statistics, I was taught in my first class, is designed to help us make sense of large and contradictory data. Since that is precisely our problem in pricing assets today, i.e., that we have too much data pulling us in too many directions, it may be time to dust off that statistics book (I hope that you did not sell it back or burn it after your last statistics class) and reacquaint yourself with simple statistics. So, start with the averages, medians and standard deviations, move on to correlations and regressions and if you can handle it, to statistical distributions. If you are lost, try this link for my statistics primer.
3. Get comfortable with rudimentary finance: I have always found it unfair that to take some classes, you have to take the equivalent of a lifetime in pre-requisites. While having taken a corporate finance class eases the way in valuation, it is not required, nor is any other finance course. That said, your life will be easier if you have nailed down the basics of time value of money and computing present value, as well as understand the roots of modern portfolio theory, even if you don 't quite get the specifics. This link has my time value of money primer.

Getting down to Specifics

It's taken me a while to get to specifics, but the class starts on September 2, 2015 and classes are every Monday and Wednesday from 10.30 am -11.50 am (with Sept 7, 14 and 23 being holidays) until December 14. The calendar for the class is available at this link. The class content will follow a familiar path, starting with a big picture perspective on valuing/pricing, followed by intrinsic valuation (DCF), relative valuation (pricing and multiples), asset-based valuation (accounting, liquidation & sum of the parts) and it will end with real options. There will be two add-on sessions on acquisition valuation and value enhancement.

If you are one of the 300 registered in the class, I hope to see you in class. If not, the classes will be recorded and webcast, usually by the end of each session day, and there are three forums you can use to follow the class:

1. My website: Everything I do in this class will be accessible on this page for the class. As you will notice on the page, you can not only access the webcasts for the lectures, but you can download the lecture notes, try your hand at the valuations of the week and even take quizzes/exams (though you have to grade them yourself). If you want, you can read the emails that I send to the class at this link.
2. iTunes U: This has become one of my favorite platforms for delivering my class and it works flawlessly, if you have an Apple device, with an iPad providing a much better experience than an iPhone. (You have to download the iTunes U app, but it is free and the learning curve is barely uphill.) However, you can tweak it to work on an Android, with an add-on app. This semester's version will be available at this link.
3. YouTube: This was my add-on platform last semester and while it was never intended for delivering full classes, it worked surprisingly well. The webcasts come naturally to it, though the 80 minutes is a stretch, but I will add on the presentation material and the post-class tests to the webcasts to supplement them. This semester, the lectures and supporting material will be found at this channel.

Alternate Pathways

This is not the first time that I have put my classes online and this may not be the first time that you have thought about taking this particular class. As with other online classes, I know that life gets in the way, with family and work commitments taking priority, as they should, over an online valuation class that provides no credit or certification. You can follow one of the following four paths, each requiring more time and brain commitment than the prior one:

1. Watch an occasional lecture or lectures: Rather than watch all 26 lectures, you can pick and choose a few on the topics that interest you the most. This strategy works best for those who cannot commit the time and/or are already experienced enough in valuation that they need just a brushing up of skill sets.
2. Watch every lecture, do post class tests/solutions: You could watch every lecture, a significant time commitment at 80 minutes apiece, and do just the post-class tests (designed to take about 5-10 minutes). Remember that you don't have to take this in real time, since the course will stay online for at least a year.
3. Watch lectures and take quizzes/exam: In addition to watching the lectures, you can put your knowledge to the test and take the quizzes and final exam. I will post my solutions with a grading template and you can grade yourself (My advice: Be an easy grader!). Since the exams are all open-book, open-notes all you have to do is honor the time constraint (30 minutes for quizzes, 2 hours for the final).
4. Watch lectures, take quizzes exam & value a company: In addition to doing all of the tasks in the prior path, you also pick a company to value (just as everyone else in my class will be) and try to apply what you learn in the class in that valuation. Unfortunately, there is little chance that I can offer you the feedback that I offer to those in my class, but I will try to answer a question or two, if you are stuck, and will provide my feedback template, when the time comes due.

If all of these pathways all sound like too much work/time commitment and/or watching 80 minute videos of valuation lectures on your phone or tablet is not your idea of fun, I do have an alternative. Try my online valuation class, where the sessions are about 10-15 minutes apiece, on my website, YouTube or iTunes U.

Pass on it or pass it on!

If you try the class and don't like it, I will not be offended and I am sure that you will find a better use for your time. If you try the class and you like it, I would like something in return. Please pass on a bit of what you know or have learned to at least one other person, and perhaps more. Knowledge is one of the few things in life that we can share, without being left poorer for the sharing, and while the return on this investment will be not be financial, the emotional dividends will make it worthwhile.

Attachments
Preview of class (YouTube)
Links
Webpage for the class (on my website)
Webpage for Valuation Online class (short sessions)
iTunes U for the upcoming class
iTunes U for the Valuation Online class (short sessions)
YouTube for the upcoming class
YouTube for the Valuation Online class (short sessions)

As the title should forewarn you, this is a post that will meander from eating spots to basketball players to corporate name changes. So, if you get lost easily, you may want skip reading it. It is triggered by two events that occurred this summer. One is Google's widely publicized decision to rename itself Alphabet and to reorganize itself as a holding company. The other is the much less public news that the eating place across the street from the building where I teach will be reopening with a new name "Brod Kitchen", a new menu, and (probably) higher prices.

Coffee Shop to Eatery to Brod Kitchen

In my post on my valuation class, I noted that this is my 30th year at New York University and I have seen the neighborhood around the school transition over time. When I started in 1986, I had my office and did the bulk of my teaching in the graduate school campus, which was downtown, but I lived near and still taught some classes at the undergraduate school. Right across the school was the Campus Coffee Shop (Yes! This is exactly what it looked like!) and it was exactly what its name suggested, an unpretentious coffee shop. The menu was primarily breakfast food, served all through the day, and the coffee came in one flavor (bitter), one texture (sludge) with only two add-ons (cream & sugar). The waiters and waitresses were all crotchety and old, viewed service as a foreign concept and I can only pity the poor person who tried to order a cappuccino or latte. To compensate, the coffee was only 50 cents, the egg sandwich about a dollar and you got what you paid for.

About 15 years into my stint at Stern, the building's landlord (a brutally oppressive tyrant named New York University) decided that the campus coffee shop was too downscale and it was replaced by the Campus Eatery. This place offered fewer seats, a wider menu with paninis replacing sandwiches (as if putting a bad sandwich in a hot press can make it a  good one) and machine-made cappuccinos that had neither milk nor espresso in them. Not surprisingly, the prices went up to reflect the name change from coffee shop to eatery, though the only edible items on the menu remained the breakfast items, albeit at twice the price you paid at the coffee shop.

At the start of this summer, I noticed that the Campus Eatery had closed and that the space was being renovated for a new restaurant. The restaurant has not opened yet (at least as of last Thursday, which was the last day I was in the city) but the name went up a few weeks ago and when I saw that it was Brod, the umlaut made me suspicious. My trusted Google search engine found another eating place with the same name in New York, and I was able to find the company's website. It looks like a bakery with a Scandinavian tilt and Northern European prices, but the only consolation price is that it could have been worse. This could have become a Le Pain Quotidien, a New York based food chain with a pretentious French name and prices to match. (A reader points out to me that it is in Brussels, but according to the company's website, it is a New York based company with branches all over the world!)
Update: I did a trial run this morning, since Brod opened. Bought an iced coffee and a Cherry Danish (in keeping with the Scandinavian theme). Cost me $9.53 and it tasted just like the iced coffee and Danish that I get from the street cart that I usually go to.. and pay $2.50 for.. So, lesson learned!

While these are three different businesses, with three different owners, they have all occupied the same space and I tend to think of them as the same eating place with three different names. That started me ruminating about why people and businesses change names and whether those name changes can affect the values that you attach to the entities involved. 

Reasons for Name Changes

I must confess that I have changed my name, though the change was more the result of happenstance than design. I grew up in South India in a period where caste names had been abandoned, but family names were not in vogue yet, and went through much of my school and college years known only by my first name (Aswath) and without a last name. It was as I was filling out my I-94 form on the my flight into the United States that I faced the question of what to use as my family name, and I used my father's first name, Damodaran, as the filler. Since then, I have seen friends and acquaintances change their names, mostly as a result of marriages, and businesses change names, with mergers being the most common trigger. However, there are other, more interesting reasons for name changes, though, and here are a few of them:

1. To decontaminate or escape: In some cases, a name may get contaminated to the point that changing it is the only way to escape the taint. When Philip Morris changed its name to Altria in 2001, it was partly an attempt to remove the taint of tobacco (and its associated lawsuits) from its then food and beverage subsidiaries (Kraft and Miller Brewing). While there may have been other reasons for Tyco Electronics to rename itself TE Connectivity in 2010, one reason may have been to disassociate itself from the accounting scandals at its parent company. 
2. To change: Changing your name can sometime make it easier for you to change yourself, as a person or how you operate, as a business. In this context, corporate name changes can cover the spectrum. Some  name changes reflect changes that have already happened, as was the case when Apple Computer became Apple in 2007, a concession to the reality that it was deriving more of its revenues and profits from its smartphones, tablets and retail than from its computer business. It can sometimes be a precursor of changes to come, as was the hope at International Harvester, when it sold off its agricultural division to Tenneco, renamed itself Navistar in 1986, and worked to make a name for itself in the diesel engine and truck chassis markets.  Finally, there is an escapist component to the some name change, where the firm is trying to  get away from troubles and hopes that changing its name will help it in the endeavor. When Research in Motion changed its name to Blackberry in 2013, it was in an attempt to divert attention from declining sales and a business in trouble. 
3. To market: To make money, you have to sell your products and services, and not surprisingly, companies are drawn to names that they perceive will make it easier for them to market. In some cases, this may require simplifying your name to make it easier for customers to relate to; Tokyo Tsushin Kogyo did the right thing in 1958, when it renamed itself Sony. In still others, it may be designed to have a name that better fits your product or service; we should all be thankful that Larry Page and Sergey Brin changed their search engine's name from Backrub to Google a year into development. Finally, the name change may be to something more exotic, in the  hope that this will give you pricing power; the only surprising thing about L’Oreal renaming of its US subsidiary, Cosmair, to L’Oreal USA was that it took so long to happen. After all, it must be a marketing maxim that having an accent in your name (the e in L’Oreal), in an Anglo-Saxon setting and that adding a apostrophe can only add to your cachet.
4. To fool: In one of the more publicized frauds of the last century, a German named Christian Gerhartsreiter managed to fool East Court elite (both society and business) into thinking that he was Clark Rockefeller, using the last name to open doors to country clubs and financial opportunities. Corporations have played their own version of this game, incorporating the hot businesses of the moment to their names, whether it be dot.com in the 1990s, oil in the last decade or social media today. 

There are two points to note. The first is that these reasons are not mutually exclusive and more than one may apply for a given name change. The other is that the lines of separation between the reasons can also be fuzzy, with the one separating marketing and fooling investors being perhaps the most difficult one to delineate.

Valuing and Pricing Name Changes

Can changing your name change your value as a business or you as an individual? You may scoff, but I do believe that there are pathways to changing behavior or increasing value that begin with a name change. You will not find them if the name change is purely cosmetic or if your reason is to fool customers or investors, but you may, with any of the other reasons. Thus, if your rationale for the name change is to remove the taint of an old name or to market your product more easily,  it should show up as higher revenues and profits, if you are right. If the name change is the first step in changing the way you run as a business, it should be manifested in your investing, financing and dividend decisions, and consequently in value. The proof, though, is in the results and it is true that the benefits are either transient or illusory in many cases.

It is much easier to see a price effect from a name change, and especially so, if your end game is fooling investors. The highest profile studies of this phenomenon have centered around the dot com era, when the renaming was visible for all to see (adding a .com to an existing name or removing it), and the evidence was striking. The first study looked at companies that added dot.com to their names in the late 1990s and found that stock prices surged by astonishingly large amounts on the news, often with no accompanying change in operating focus or business practices. The second study looked at companies that removed dot.com from their names after the dot.com bust in 2000 and 2001 and uncovered an equally unsetting market reaction, i.e., that stock prices surged on the removal, again with no really accompanying shift in fundamentals. The results from both studies are graphed below:

To back up the proposition that this is not just a phenomenon in technology stocks are unique to that time period in market history, a study looked at US and Canadian companies that added "oil" or "petroleum" to their names between 2000 and 2007, a period when oil prices are booming, and found that stock prices reacted positively to the addition, with US investors greeting the name change more effusively than Canadian investors. If history is any guide, these companies will now gain by removing "oil" from their names today, with oil prices at historic lows.

What are the lessons from these studies? The first is that names do matter in markets and that companies sometimes choose names to please markets. The perils, as you can see even from the limited evidence that I have presented, is that investors are fickle and can change their minds and that a name that is value additive today can become value destructive in a while. 

Google's Alphabet Soup

A few weeks ago, Google shook up markets with its announcement that it was revamping the structure of the company, creating a holding company (Alphabet), with the core products of Google including Search, Ads, Maps, Apps, Android and YouTube, in one subsidiary (Google) and its experimental ventures in new businesses in other subsidiaries (though we will have to wait on the specifics). The immediate market reaction was positive, but as we noted in the last section, that effect can fade quickly. The longer term questions are two fold. Why did Google change its corporate name? Will the name change work?

On the first question, it is my view that three of the reasons listed earlier can be ruled out almost immediately. Given how successful Google has been as a company, in terms of generating earnings and value for its investors, it is implausible that the company would want to disassociate itself from on of the most recognized brand names in the world. From a marketing perspective, it seems inconceivable to me that it will be easier to sell an "Alphabet" product than a "Google" product, and I don't think that there are very many investors out there who see lots of money making potential in the alphabet. Thus, the only motive that we are left with is that the name change is designed to  change the way the company operates. 

If change is the rationale, the timing seems odd, given that Google just reported exceptional results in its last earnings report, triggering a 16% increase in market capitalization on the news. It is true, though, that Google is still a single-business company, deriving almost all of their revenues from advertising, and that all of its attempts to diversify its business mix have generated more publicity than profits. It is possible that the renaming and reorganization are designed to fix this problem, but will it work? I am skeptical, partly because there is talk that Page and Brin were using Berkshire Hathaway as a model, which makes no sense to me, since the two organizations have very little in common (other than large market capitalization). As I see it, Berkshire Hathway is a closed-end mutual fund, funded with insurance capital, and run by the best stock picker(s) in history, and its holding structure is consistent with that description, where Buffet and Munger have historically picked up under valued, well managed companies as investments, and left the managers in these companies alone. Google, in contrast, is composed of one monstrously successful online advertising business (composed of Google search, YouTube and add ons) and several start-ups that so far have been more adept at spending money than generating earnings.

If this name change is designed to alter that reality, it has to attack what I see as Google's two big problems. The first is what I term the Sugar Daddy Syndrome, where the earnings power and cash flow generating capacity of Google's advertising business has made its start ups too sloppy in their investments, secure in the knowledge that they have access to an endless source of additional capital.  (Update: Those who are more knowledgeable about Google's ways have pointed out to me that it is quick to lop of projects that don't work, which then makes its new product failures an even bigger mystery. Perhaps, this is a case of a Sugar Daddy with Attention Deficit Disorder!) The second is that Google, for better or worse, has been run as a Benevolent Dictatorship, with Larry Page and Sergey Brin calling the shots at every turn. The fact that Sundar Pichai, the new CEO of the Google portion of the Alphabet, is little known can be viewed as a sign of his modesty and self-effacing nature, but it is also a reflection of the outsized profiles that Page and Brin have had at Google.  So, for this name change to work, it has to solve both problems, and here are the signs that will indicate that it is working. First, I would like to see Google refuse to invest in one or more of its start-ups, on the grounds of non-performance and invest in or acquire a competing start-up in the same business.   Alphabet's new ventures become more like good start-ups, lean, mean and looking for pathways to make money, and Google Advertising behave more like a seasoned VC, looking for the best place to invest its money, inside or outside the company. (For those in the tech business who schooled me on Google's ways, thank you! I have much to learn!) Second, I would also like to see Mr. Pichai deny capital to a project that is prized by Page and Brin, and have them not over rule that decision. Given the history of Google's founders, the likelihood of these events happening is low, but I give Google better odds than I did Ron Artest, an NBA player with anger management issues, when he changed his name to Metta World Peace in 2011.

What's in a name?
If value is driven by substance (cash flows, growth and risk), it seems absurd that name changes can affect your value, but I have learned not to dismiss them as non-events. Name changes can lead to shifts in investment, financing and dividend policy that can affect value, but more important, they can have substantial price effects. That may seem irrational, but it is ironic that academics in finance would be so quick to make the judgment that what you name something cannot alter its value or significance. After all, these same academics have learned that attaching letters from the Greek alphabet to their measures of risk (beta) or performance (alpha) provide these measures with a power that they would never possess otherwise. So, who knows? These name changes may all work: Brod Kitchen might deliver delicious and cheap food, Page and Brin may actually be willing to give up control at Google and Ron Artest could become a Buddhist monk!

YouTube Webcast

I have used Vale as an illustrative example in my applied corporate finance book, and as a global mining company, with Brazilian roots, it allows me to talk about how financial decisions (on where to invest, how much to borrow and how dividend payout) are affected by the ups and downs of the commodity business and the government’s presence as the governance table. In November 2014, I used it as one of two companies (Lukoil was the other one) that were trapped in a risk trifecta, with commodity, currency and country risk all spiraling out of control. In that post, I made a judgment that Vale looked significantly under valued and followed through on that judgment by buying its shares at $8.53/share. I revisited the company in April 2015, with the stock down to $6.15, revalued it, and concluded that while the value had dropped, it looked under valued at its prevailing price. The months since that post have not been good ones for the investment, either, and with the stock down to about $5.05, I think it is time to reassess the company again.

Spreadsheet: http://www.stern.nyu.edu/~adamodar/pc/blog/ValeNov2014.xls

Spreadsheet: http://www.stern.nyu.edu/~adamodar/pc/blog/ValeApril2015.xls

Source: Bloomberg

Spreadsheet: http://www.stern.nyu.edu/~adamodar/pc/blog/ValeSept2015.xls

http://aswathdamodaran.blogspot.com.ar/2015/09/no-...

Mod Note (Andy) - as the year comes to an end we're reposting the top discussions from 2015, this one ranks #35 and was originally posted 2/24/2015.

Earlier this year, I started my series on discounted cash flow valuations (DCF) with a post that listed ten common myths in DCF and promised to do a post on each one over the course of the year. This is the first of that series and I will use it to challenge the widely held misconception that all you need to arrive at a DCF value is a D(iscount rate) and expected C(ash)F(lows). In this post, I will take a tour of what I would term twisted DCFs, where you have the appearance of a discounted cash flow valuation, without any of the consistency or philosophy.

• Equity versus Business (Firm): If the cash flows are after debt payments (and thus cash flows to equity), the discount rate used has to reflect the return required by those equity investors (the cost of equity), given the perceived risk in their equity investments. If the cash flows are prior to debt payments (cash flows to the business or firm), the discount rate used has to be a weighted average of what your equity investors want and what your lenders (debt holders) demand or a cost of funding the entire business (cost of capital).
• Pre-tax versus Post-tax: If your cash flows are pre-tax (post-tax), your discount rate has to be pre-tax (post-tax). It is worth noting that when valuing companies, we look at cash flows after corporate taxes and prior to personal taxes and discount rates are defined consistently. This gets tricky when valuing pass-through entities, which pay no taxes but are often required to pass through their income to investors who then get taxed at individual tax rates, and I looked at this question in my post on pass-through entities.
• Nominal versus Real: If your cash flows are computed without incorporating inflation expectations, they are real cash flows and have to be discounted at a real discount rate. If your cash flows incorporate an expected inflation rate, your discount rate has to incorporate the same expected inflation rate.
• Currency: If your cash flows are in a specific currency, your discount rate has to be in the same currency. Since currency is primarily a conduit for expected inflation, choosing a high inflation currency (say the Brazilian Reai) will give you a higher discount rate and higher expected growth and should leave value unchanged.

1. The Chimera DCF: In mythology, a chimera is usually depicted as a lion, with the head of a goat arising from his back, and a tail that might end with a snake's head. A DCF valuation that mixes dollar cash flows with peso discount rates, nominal cash flows with real costs of capital and cash flows before debt payments with costs of equity is violating basic consistency rules and qualifies as a Chimera DCF. It is useless, no matter how much work went into estimating the cash flows and discount rates. While it is possible that these inconsistencies are the result of deliberate intent (where you are trying to justify an unjustifiable value), they are more often the result of sloppiness and too many analysts working on the same valuation, with division of labor run amok.
2. The Dreamstate DCF: It is easy to build amazing companies on spreadsheets, making outlandish assumptions about growth and operating margins over time. With attribution to Elon
   

   Musk, I could take a small, money losing automobile company, forecast enough revenue
   

   growth to get its revenues to $350 billion in ten years (about $100 billion higher than  Toyota or Volkswagen, the largest automobile companies today), increase operating margins to 10% by the tenth year (giving it the margins of  premium auto makers) and make it a low risk, high growth company at that point (allowing it to trade at 20 times earnings at the end of year 10), all on a spreadsheet. Dreamstate DCFs are usually the result of a combination of hubris and static analysis, where you assume that you act correctly and no one else does.

3. The Dissonant DCF: When assumptions about growth, risk and cash flows are not consistent with each other, with little or no explanation given for the mismatch, you have a DCF valuation
   

   where the assumptions are at war with each other and your valuation error will reflect the input
   

   dissonance. An analyst who assumes high growth with low risk and low reinvestment will get too high a value, and one who assumes low growth with high risk and high reinvestment will get too low a value.  I attributed dissonant DCFs to the natural tendency of analysts to focus on one variable at a time and tweak it, when in fact changes in one variable (say, growth) affect the other variables in your assessment. In addition, if you have a bias (towards a higher or lower value), you will find a variable to change that will deliver the result you want.

4. The Trojan Horse (or Drag Queen) DCF: It is undeniable that the biggest number in a DCF is the terminal value, and for it to remain a DCF (a measure of intrinsic value), that number has to be estimated in one of two ways. The first is to assume that your cash flows will continue
   

   beyond the terminal year, growing at a constant rate forever (or for a finite period) and the second is to assume liquidation, with the liquidation proceeds representing your terminal value. There are many DCFs, though, where the terminal value is estimated by applying a multiple to the terminal year’s revenues, book value or earnings and that multiple (PE, EV/Sales, EV/EBITDA) comes from how comparable firms are being priced right now. Just as the Greeks used a wooden horse to smuggle soldiers into Troy, analysts are using the Trojan horse of expected cash flows (during the estimation period) to smuggle in a pricing. One reason analysts feel the urge to disguise their pricing as DCF valuations is a reluctance to admit that you are playing the pricing game.

5. The Kabuki of For-show DCF: The last three decades have seen an explosion in valuations for legal and accounting purposes. Since neither the courts nor accounting rule writers have a clear
   

   sense of what they want as output from this process (and it has little to do with fair value), and there are generally no transactions that ride on the numbers (making them "show" valuations), you get checkbox or rule-driven valuation. In its most pristine form, these valuations are works of art, where analyst and rule maker (or court) go through the motions of valuation, with the intent of developing models that are legally or accounting-rule defensible rather than yielding reasonable values. Until we resolve the fundamental contradiction of asking practitioners to price assets, while also asking them to deliver DCF models that back the prices, we will see more and more Kabuki DCFs.

6. The Robo DCF: In a Robo DCF, the analyst build a valuation almost entirely from the most recent financial statements and automated forecasts. In its most extreme form, every input in a
   

   Robo DCF can be traced to an external source, with equity risk premiums from Ibbotson or Duff and Phelps, betas from Bloomberg and cash flows from Factset, coming together in the model to deliver a value. Given that computers are much better followers of rigid and automated rules than human beings can, it is not surprising that many services (Bloomberg, Morningstar) have created their own versions of Robo DCFs to do intrinsic valuations. In fact, you could probably create an app for a smartphone or tablet that could do valuations for you..

7. The Mutant DCF: In its scariest form, a DCF can be just a collection of numbers where items have familiar names (free cash flow, cost of capital) but the analyst putting it together has
   

   neither a narrative holding the numbers together nor a sense of the basic principles of valuation. In the best case scenario, these valuations never see the light of day, as their creators abandon their misshapen creations, but in many cases, these valuations find their way into acquisition valuations, appraisals and portfolio management.

In my last post, I looked at the determinants of country risk and attempts to measure that risk, by risk measurement services, ratings agencies and by markets. In this post, I would first like to focus on how investors and business people can incorporate that risk into their decision-making. In the process, I will argue that while it is easy to show that risk varies across countries, significant questions remain on how best to deal with that risk when making investment and valuation judgments.

Valuing Country Risk

If the value of an asset is the risk-adjusted present value of its expected cash flows, it stands to reason that cash flow claims in riskier countries should be worth less than otherwise cash flow claims in safer parts of the world. This common-sense principle, though, can be complicated in practice, because there are two ways in which country risk can flow through into value.

1. Adjust expected cash flows: The first is to adjust the expected cash flows for the risk, bringing in the probability of an adverse event occurring and computing the resulting effect on cash flows. In effect, the expected cash flows on an investment will be lower in riskier countries than an otherwise similar investment in safer countries, though the mechanics of how we lower the cash flows has to be made explicit.
2. Modify required return: The second is to augment the required return on your investment to reflect additional country risk. Thus, the discount rate you use for cash flows from an investment in Argentina will be higher than the discount rate that you use for cash flows in Germany, even if you compute the discount rate in the same currency (US dollars or Euros, for instance). The question of whether there should be an additional premium for exchange rate risk is surprisingly difficult to answer, though I will give it my best shot later in this post.

While both processes are used by analysts, the adjustments made to cash flows and discount rates are often arbitrary and risk is all too often double counted. The questions of which types of risks to bring into the expected cash flows and which ones into discount rates but also how to do so remain open and I will lay out my perspective in this post.

Adjust Cash Flows

If there is a probability that your business can be adversely impacted by risk in a country, it stands to reason that you should incorporate this effect into your expected cash flow. There are three ways that you can make this adjustment.

1. Probabilistic adjustment: The first is to estimate the likelihood that a risky event will occur, the consequences for value and cash flow if it does and to compute an expected value. This is the best route to follow for discrete, country-specific risks that can have large or catastrophic effects on your business value, since discount rates don't lend themselves easily to discrete risk adjustment and the fact that the risk is country-specific suggests that globally diversified investors may be able to diversify away some or much of the risk. A good example would be nationalization risk in a country prone to expropriating private businesses, where bringing in its likelihood will lower expected earnings in future periods and cash flows.
2. Build in the cost of protection: The second approach is to estimate the cost of buying protection against the country risk in question and bring in that cost into your expected cash flows. Thus, if you could buy insurance against nationalization, you could reduce your expected earnings by that insurance cost and use those earnings as a basis for estimating cash flows. This approach is best suited to those risks that can be insured against either in the insurance or financial markets. It is also my preferred approach in dealing with corruption risk, which, as I have argued in a prior post, is more akin to an unofficial tax imposed on the company.
3. Cash flow hair cuts: The third way to adjust for country risk is to lower expected cash flows in risky countries 10%, 20% or more, with the adjustment varying across countries (with bigger hair cuts for riskier countries) and analysts (with more risk averse analysts making larger cuts). The perils of this approach are numerous. The first is that it is not only arbitrary but it is also specific to the individual making it, causing it to vary from investment decision to decision and from analyst to analyst. The second is that, once made, the adjustment is hidden or implicit and subsequent decision makers may not be aware that it has already been made, resulting in multiple risk adjustments at different levels of the decision-making process.

A key distinction between the first approach (probabilistic) and the other two (building in cost of insuring risk or haircutting cash flows) is that taking into account the probability that your business could be adversely impacted by an event and adjusting the expected cash flows for the impact does not "risk adjust" the cash flows. You will attach the same value to a risky business as you would to a safe business with the same expected cash flows.

Adjust Required Returns

The second approach to dealing with country risk is to adjust discount rates, pushing up the required returns (and discount rates) for investments made in riskier countries. Those higher rates will push down value, thus accomplishing the same end result as lowering expected cash flows.

Fixed Cash Flow Claims (Fixed Income)

With fixed income claims (bonds, financial guarantees), this is easy enough to do, requiring an additional default spread (for country risk) in the desired interest rate, which, in turn, will lower value. In my last post on country risk, I looked at measures of sovereign default risk including sovereign ratings and credit default swaps. If you have a fixed cash flow claim against a sovereign, you could use these default risk measures to calculate the value of these claims. Thus, if the sovereign CDS spread for Brazil is 2.91% and the risk free rate in US dollars is 2.47%, you would price Brazilian dollar denominated bonds or fixed obligations to earn you 5.38%.

But what if your claim is against a company or business in a risky country? There are two ways in which you could estimate the default spread that you would use to value this claim:

1. Company Rating: Just as ratings agencies and CDS markets estimate default risk in sovereigns, they also estimate default risk in some companies, especially larger ones. If your fixed cash flow claim is against a company where one or both of these are available, you can use them to compute an expected return (and discount your fixed claims at that rate). To illustrate, Vale, a Brazilian mining company, has a bond rating of Baa2 from Moody's in July 2015, and the default spread for a Baa2 rated bond rated bond is 1.75%. Since ratings agencies already incorporate (at least in theory) the fact that Vale is a Brazilian company into the bond rating, there is no need to consider country risk.

US dollar cost of debt for Vale = US $ Risk free rate + Default Spread based on rating = 2.25%+1.75% = 4.00%

2. Country Default Spread + Company Default Spread: For many companies in emerging markets, the first approach will be a non-starter, and for these companies, you will have to approach the cost of debt estimation in two steps. In the first step, you will have to assess the default risk of the company, using its financial statements; I use an interest coverage ratio to estimate a synthetic bond rating and a default spread. In the second, you have to estimate the default spread for the country in which the company is incorporated. For smaller companies that have no way of avoiding the country risk, the US dollar cost of debt becomes:

US dollar cost of debt for company = Risk free rate + Company Default Spread + Country Default Spread

To illustrate, I estimated a synthetic rating of AAA for Bajaj Auto, an Indian auto manufacturer. To get Bajaj Auto's cost of debt in US dollars, I would add the default spread based on this rating (0.40%) and the default spread for India (2.20%) to the US dollar risk free rate (2.25%), yielding a composite value of 4.65%. For larger companies with some or a great deal of global exposure, it is possible that only a portion of the country default spread will apply.

Residual Cash Flow Claims (Equity)

When valuing equity claims, the process of adjusting for country risk becomes more complicated. First, since equity claim holders don't get paid until the fixed cash flow claims have been met, they face more risk and should demand higher rewards for bearing that risk. Second, since equity investors can diversify away some risks, it is possible for a global investor to be exposed to these risks at the country level and still not demand a higher required return for these risks. Thus, if you are augmenting your required returns for country risk, you are arguing that some country risk is not diversifiable to the investors pricing the company exposed to that risk either because they don't have the capacity to diversify away that risk (by holding a globally diversified portfolio) or because there is correlation across countries that results in even globally diversified portfolios continuing to be exposed to country risk. Third, a multinational company is exposed to risky in many countries and not just to the risk of the country in which it is incorporated. Consequently, you have to separate the estimating of risk premiums for countries from that of risk premiums for companies.

Equity Risk Premiums

In earlier posts on this topic, I describe the process by which I estimate equity risk premiums for countries. Briefly summarizing, I start with a premium that I estimate for the S&P 500 at the start of every month as my "mature market premium" and add to that premium an additional country risk premium for riskier countries. I use either the sovereign rating or CDS spread as my measure of country risk, treating all countries with ratings of Aaa (AAA) or sovereign CDS spreads close to the US CDS spread as mature markets and estimating the equity risk premium for other markets as follows:

To illustrate, my estimate of the equity risk premium for the S&P 500 at the start of July 2015 was 5.81%, and my estimate of the equity risk premium for Brazil (with its Baa2 sovereign rating and 1.90% default spread at the start of July) is 8.82%:

The standard deviations of the Bovespa (20.25%) and the Brazilian government bond (12.76%) are used to scale up the default spread to yield an equity risk premium of 8.82%.

Using this approach and extrapolating across countries, I obtained updated equity risk premiums for 169 countries in July and the results are contained in this data set. The global picture of equity risk, at least as I see it, is in below:

Company Exposure to Equity Risk

The standard practice in valuation is to look at a company's country of incorporation and assign an equity risk premium to it, based on that choice, a practice that has its roots in simpler times when much or all of most companies' revenues came from domestic markets and where multinationals were the exception, rather than the rule.

That practice is indefensible in today's markets where most companies, including many small firms, derive their revenues from across the globe and often have their production spread over many countries. It makes far more sense to take a weighted average of equity risk premiums across these many markets to get to a company equity risk premium. The equity risk premiums themselves can be weighted on any of the following:

1. Revenues: To the extent that your revenue stream is dependent upon the economic health of the country from which it is derived, you could argue that it is revenue that you should be focusing on.
2. EBITDA or Earnings: Since value is a function of cash flows (and not revenues), you may be inclined to use the EBITDA, by region, to weight equity risk premiums. There are three concerns you should have, though. The first is that many companies don't break down EBITDA, by region, while most break down revenues globally. The second is that accounting judgments come into play when assessing earnings by region, since expenses have to be allocated across regions. Much as we would like to believe that these allocations are driven by economic fundamentals, it is undeniable that tax considerations play a role. Third, unlike revenues which are always positive, the EBITDA for a region can be negative and it is not clear how you deal with negative weights.
3. Assets: If you are an asset-based company (real estate or hospitality), your primary exposure to country risk may be at the asset level, and your most logical basis for computing an equity risk premium is to weight it based on assets. As with earnings, companies are not always forthcoming breaking down assets and even when broken down, the reported values tend to be book values (rather than market values).
4. Production: In some cases, your primary exposure to risk may be to your operations rather than your revenue streams. In other words, if country risk leads you to shut down your factories, refineries or mines, it does not matter where you generate your revenues. Thus, with natural resource companies and companies that require significant infrastructure investments, you may choose to weight based upon where your production is centered. This is rarely reported in full in most company financials, though you may be able to guess, if you are familiar with the company.

To illustrate, Coca Cola, while headquartered in the United States, has revenues across much of the globe and its 2014 annual report breaks revenues down into geographical regions. Using that revenue breakdown with the weighted ERP of each region from the last section, we estimate an equity risk premium of 6.90% for Coca Cola.

Consider Vale, a commodity company, instead. Its revenue breakdown on 2014 is below, with a weighted equity risk premium of 7.39% for the company.

As you can see, Vale is more exposed to Chinese country risk than Brazilian country risk, at least based on revenues. As a commodity company, you could argue that some of Vale's risks come from where its iron ore/mining reserves lie and that the equity risk premium should reflect that at as well. I agree, but Vale is still surprisingly opaque when it comes to the geographical breakdown of its operations.

Bringing it together

Since country risk can take many different forms and the way you should deal with it varies widely depending on that form, the picture below is designed to capture how best (at least from my perspective) to incorporate risk into value.

There are three keys to dealing with country risk.

1. Look at country risk through the eyes of investors in your company: Many businesses, when looking at country risk, tend to look at how exposed they are to the risk, when they should be looking at risk exposure through the eyes of their investors.
2. Make your risk adjustment(s) transparent: Whatever adjustment you make for country risk, it should be transparent. Put differently, if you adjust discount rates for country risk, your country risk adjustment should be visible to others who may look at your valuation. In far too many valuations, the adjustments for country risk are implicit, thus making it impossible for others to understand the adjustments or take issue with them.
3. Do not double count or triple count risk: In a surprisingly large number of valuations, risk is double counted. Thus, it is not uncommon to see government bond rates that are not risk free being used as risk free rates, multiple hair cuts to the same cash flows and the same risk being adjusted for in both the cash flows and discount rate.

One of the key requirements in operating a business globally is understanding how risk varies across countries and incorporating those risk assessments into whether and where you invest your (or your business) money. In these last two posts, I have tried to provide my perspective on both measuring risk differences across countries and how I think this risk should enter your investment decisions. It is true that both posts have avoided the questions of how the market prices these risks and of how currency risk enter the process, which you may view as glaring omissions, I will deal with the pricing question in my next post and look at decoding the currency puzzle in my last one.

Paper to read:
My paper on country risk (July 2015)

Data attachment:
Equity Risk Premium by Country (July 2015)

Spreadsheet:
Company Risk Premium Calculator

In my last two posts, I looked at country risk, starting with an examination of measures of country risk in this one and how to incorporate that risk into value in the following post. In this post, I want to look at an alternative way of dealing with country risk, especially in investing, which is to let the market price of country risk govern decisions.

Pricing Country Risk

If you are not a believer in discounted cash flow valuations, I understand, but you still have to consider differences in country risk in your investing strategies. If you use pricing multiples (PE, Price to Book, EV to EBITDA) to determine how much you will pay for companies, you could assume that the levels of these multiples in a country already incorporate country risk. Thus, you are assuming that the PE ratios (or any other multiple) will be lower in riskier countries than in safer ones.

It is easy to illustrate the impact of risk on any pricing multiple, with a basic discounted cash flow model and simple algebra. To illustrate, note that you can use a stable growth dividend discount model to back into an intrinsic PE:

Dividing both sides of this equation by earnings, we derive an intrinsic PE ratio:

The PE ratio that you should expect to observe in a country will be a function of the efficiency with which firms generate earnings (measured by the payout ratio), the expected growth in these earnings (g) and the risk in these earnings (captured by the cost of equity). Holding the growth and earnings efficiency constant, then, you should expect to see lower PE ratios in countries with higher risk and higher PE ratios in safer countries. You can use the same process to extract the determinants of price to book ratios or enterprise value multiples and you will arrive at the same conclusion.

Equity Multiples

To see how well this pricing paradigm works, I started by looking at PE ratios by country in July 2015. To estimate the PE ratio for a country, I tried three variants. In the first, I compute the PE ratio for each company in the country (where it was computable) and then average across these PE ratios. To the extent that there are small companies with outlandish PE ratios in the sample (and there are many), these ratios will be skewed upwards. In the second, I compute a weighted average PE ratio across companies, with the weights based upon net income. This ratio is less affected by outliers, but it excludes money losing firms (since the PE ratio is not meaningful for these companies). In the third, I add up the market values of equity across all companies in the market and divide by aggregated net income for all companies, including money losing companies, i.e., an aggregated PE ratio. This ratio has the advantage of including all listed firms in a market but big money losing firms will push this measure up. The picture below summarizes differences in PE ratios across the world, with the weighted average PE ratio as the primary measure, but with the all three reported for each country.

As you can see PE ratios are noisy, with some very risky countries (like Venezuela) trading at high PE ratios and safe countries at lower values, not surprising given how much earnings can shift from year to year. For the most part, the riskiest countries are the ones where stocks trade at the lowest multiple of earnings.

To get a more stable measure of pricing, I computed price to book values by country, again using the simple and weighted averages across companies and aggregated values and report the weighted average Price to Book in the picture below:

As with PE ratios, there are outliers and Venezuela still stands out with an absurdly high price to book ratio, incongruous given the risk in that country. For the most part, though, the PBV ratio is correlated with country risk, as you can see in this list of the 28 countries that have price to book ratios that are less than one in July 2015:

Enterprise Value Multiples

Both PE and PBV ratios are equity multiples and may reflect not just country risk but also variations in financial leverage across countries. To remedy this problem, I look at EV to EBITDA multiples across countries:

Looking at this map, it is quite clear that there is much less correlation between EV/EBITDA multiples and country risk than there is with the equity multiples. While it is true that the lowest EV/EBITDA multiples are found in the riskiest parts of the world (Russia & Eastern Europe, parts of Latin America and Africa), the highest EV/EBITDA multiples are in India and China.

There are two ways of looking at these results. The optimistic take is that if you have to pick a multiple to use compare companies that are listed in different markets, you should use an enterprise value multiple, since it is less affected by country risk. The pessimistic take is that you are likely to over value emerging market companies, if you use EV/EBITDA multiples, since they are less likely to incorporate country risk.

Using these multiples

The standard approach to pricing a company is to choose a multiple and compare how stocks that you deem "comparable" are being priced based on that multiple. This approach can be extended to deal with country risk, albeit with some limitations, in one of four ways:

1. Compare how stocks listed in a country are priced to find "bargains": You could compare PE ratios across Brazilian companies on the assumption that Brazilian country risk is already incorporated in the pricing and buy (sell) the lowest (highest) PE stocks. The danger with this approach is that you are assuming that all Brazilian companies are equally exposed to Brazilian country risk.
2. Compare how stocks within a sector in a country are priced: Rather than compare across all stocks in a market, you could compare stocks within a sector in that market, on the assumption that both country and sector risk are already in the prices. Thus, you could compare the EV/Sales ratios of Brazilian retailers and argue that the retailers that trade at the lowest multiples of revenues are cheapest. The downside is that you may not find enough companies in a country, especially in a smaller market.
3. Compare how stocks within a sector are priced globally: A logical outgrowth of globalization is to compare companies within a sector, even if they are listed in different countries. Thus, you could compare Vale to other mining companies listed globally and Coca Cola to beverage companies across countries. The benefit is that you have more comparable firms but the danger is that you are ignoring country risk.
4. Compare stocks within a sector are priced globally, but control for country risk: In this last approach, you look at the pricing of companies across a sector but try to control for country risk by looking at differences between how the market is pricing companies in developed markets and emerging markets.

No matter which approach you use, you have the pluses and minuses of pricing. The plus is that you will always be able to find "cheap" stocks, because you are making relative judgments and it is simple to get the data. The minus is that if stocks are collectively over priced, either at a country or sector level, a pricing comparison will just yield the least over priced stock in the country or sector.

Valuing and Pricing: Final Thoughts

In my last post, I looked at ways in which you can try to incorporate country risk into the values of companies. In this one, I looked at how price these companies, based upon how the market is pricing other companies in risky countries. As I have argued in my posts on price versus value, the two approaches can yield divergent numbers and conclusions. Thus, you could value a company with all its operations in China, using an appropriate equity risk premium for China, and conclude that the stock is over valued. You could then compare the PE ratio for the same company to the PE ratio for the Chinese market and decide that it is cheap, because it trades at a lower multiple of earnings than a typical Chinese company.

I tend to go with the first approach, since I have more faith in my valuation abilities than in my pricing abilities, i.e., I am more investor than trader. However, I am not quick to dismiss those who use pricing metrics to pick investments, since a nimble trader can play the pricing game very profitably. If you are unsure about where you fall in this process, I would suggest that you both value and price companies and buy only when both signal that the stock is a bargain.

Paper to read:
My paper on country risk (July 2015)

Data attachment:
Equity and EV Multiples by Country: July 2015

In my last three posts, I have looked at country risk, starting with measures of that risk and then moving on to valuing and pricing that risk. You may find it strange that I have not mentioned currency risk in any of these posts on country risk, but in this one, I hope to finish this series by looking first at how currency choices affect value and then at the dynamics of currency risk.

Currency Consistency

A fundamental tenet in valuation is that you have to match the currency in which you estimate your cash flows with the currency that you estimate the discount rate that you use to discount those cash flows. Stripped down to basics, the only reason that the currency in which you choose to do your analysis matters is that different currencies have different expected inflation rates embedded in them. Those differences in expected inflation affect both our estimates of expected cash flows and discount rates. When working with a high inflation currency, we should therefore expect to see higher discount rates and higher cash flows and with a lower inflation currency, both discount rates and cash flows will be lower. In fact, we could choose to remove inflation entirely out of the process by using real cash flows and a real discount rate.

Currencies and Discount Rates

There are two ways in which you can incorporate the expected inflation in a currency into the discount rate that you estimate in that currency. The first is through the risk free rate that you use for the currency, since higher expected inflation should result in a higher risk free rate. The second is by converting the discount rate that you estimate in a base currency into a discount rate in an alternate currency, using the differential inflation between the currencies.

a. Risk free rate

A risk free rate is more than just a number that you look up to estimate discount rates. In a functioning market, investors should set the risk free rate in a currency high enough to cover not only expected inflation in that currency but also to earn a sufficient real interest rate to compensate for deferring consumption.

Risk free rate in a currency = Expected inflation in that currency + Real interest rate

The risk free rate should therefore be higher in a high-inflation currency than using that higher rate should bring inflation into your discount rate.

But how do we get risk free rates in different currencies? While most textbooks would suggest using the rate on a government bond, denominated in the currency in question, that presumes that governments are default free and that the government bond rate is a market-determined rate. However, governments are not always default free (even with local currency borrowings) and the rate may not be market-set. In July 2015, I started with the government bond rates in 42 currencies and cleansed them of default risk by subtracting out the sovereign default spreads (based on local currency sovereign ratings) from them to arrive at risk free rates in these currencies, which you can find in the table below:

Note that the default spread is set to zero for all Aaa rated governments, and the government bond rate becomes the risk free rate in the currency. Thus, the risk free rates in US dollars is 2.47% and in Swiss Francs is 0.16%. To compute the risk free rate in $R (Brazilian Reais), I subtract out my estimate of the default spread for Brazil (1.90%, based on its Baa2 rating) from the government bond rate of 12.58% to arrive at a risk free rate of 10.68%. To estimate a cost of equity in nominal $R for an average risk company with all of its operations in Brazil, you would use the 10.68% risk free rate in $R and the equity risk premium of 8.82% that I reported in my last post to arrive at a cost of equity of 19.50% in $R. That number would be higher for above-average risk companies, with a beta operating as your scaling mechanism.

b. Differential inflation

There are two problems with the risk free rate approach. The first is that it not only requires that you be able to find a government bond rate in the currency that you are working with, but also that the rate be a market-determined number. It remains true that in much of the world, government bond rates are either artificially set by governments or actively manipulated to yield unrealistic values. The second is that you are adding equity risk premiums that are computed in dollar-based markets (since the default spreads that they are built upon are from dollar-based bond or CDS markets) to risk free rates in other currencies. You could legitimately argue that the equity risk premium that you add on to a $R risk free rate of 10.68% should be higher than the 8.82% that you added to a US $ riskfree rate of 2.25% in July 2015.

If the differences between currencies lies in the fact that there are different expectations of inflation embedded in them, you should be able to use that differential inflation to adjust discount rates in one currency to another. Thus, if the cost of capital is computed in US dollars and you intend to convert it into a nominal $R cost of capital, you could do so with the following equation:

To illustrate, if you assume that the expected inflation rate in $R is 9.5% and in US $ is 1.5%, you could compute the cost of equity in US$ and then adjust for the differential inflation to arrive at a cost of equity in $R:
Cost of equity for average risk Brazilian company in US $ = 2.25% + 8.66% = 10.91%

The cost of equity of 19.65% that we derive from this approach is higher than the 19.50% that we obtained from the risk free rate approach and is perhaps a better measure of cost of equity in $R.

This approach rests on being able to estimate expected inflation in different currencies, a task that is easier in some than others. For instance, getting an expected inflation rate in US dollars is simple, since you can use the difference between the 10-year T.Bond rate and the TIPs (inflation-indexed) 10-year bond rate as a proxy. In other currencies, it can be more difficult, and you often only have past inflation rates to go with, numbers that are prone to government meddling and imperfect measurement mechanisms. Notwithstanding these problems, I report inflation rates in different countries, using the average inflation rate from 2010-2014 for each country.

I also report the inflation rate in 2014 and the IMF expectations for inflation (though I remain dubious about their quality) for each country.

Currencies and Cash Flows

Following the currency consistency principle is often easier with discount rates, where your inflation assumptions are generally either explicit or easily monitored, than it is with cash flows, where these same assumptions are implicit or borrowed from others. If you add in accounting efforts to adjust for inflation and inconsistencies in dealing with it to the mix, it should come as no surprise that in many valuations, it is not clear what inflation rate is embedded in the cash flows.

a. Inflation in your growth rates

In most valuations, you start with base year accounting numbers on revenues, earnings and cash flows and then attach growth rates to one or more of these numbers to get to expected cash flows in the future. At the risk of stating the obvious, the expected inflation rate embedded in this growth rate has to be the same inflation rate that you are incorporating in your discount rate. This simple proposition is put to the test, though, by the ways in which we estimate these expected growth rates, which is to use history, trust management/analyst projections for the future or base it on fundamentals (how much the company is reinvesting and how well it is reinvesting):

1. Past Growth: With historical growth, where you estimate growth by looking at the past, your biggest exposure to mismatches occur in currencies where inflation rates have shifted significantly over time. For instance, assume that you are valuing your company in Indian rupees in July 2015 and that the average inflation rate in India, which was 8% between 2010 and 2014 is expected to decline to 4% in the future. If you use historical growth rates in earnings, between 2010 and 2014, for an Indian company, you are likely to over value the company because its past growth rate will reflect past inflation (8%) but your discount rates, computed using expected inflation or current risk free rates in rupees, will reflect a much lower inflation rate.
2. Management/Analyst Forecasts: With management or analyst forecasts, the problem is a different one, since the expected inflation rates that individuals use in their forecasts can vary widely. While there is no reason to believe that your estimate of expected inflation is better than theirs, it is undeniably inconsistent to use management estimates of expected inflation for growth rates and your own or the market's estimates of inflation, when estimating discount rates.
3. Fundamental or Sustainable Growth: I believe that the best way to keep your valuations internally consistent is to tie growth to how much a company is reinvesting and how well it is reinvesting. The measures we use to measure reinvestment and the quality of investment are accounting numbers and inflation mismatches can enter insidiously into valuations. Assume, for instance, that you are estimating reinvestment rates and returns on capital for a Brazilian company, using its Brazilian financial statements. Since Brazilian accounting allows for inflation adjustments to assets, the return on capital that you compute is closer to a real return on capital (with no or low inflation embedded in it) than to a nominal $R return on capital, if inflation accounting works as advertised. In countries like the United States, where assets are not adjusted for inflation, you can argue that the return on capital is a nominal number, but one that reflects past inflation, not expected future inflation. In either case, the growth rate that you compute from these numbers will be skewed.

b. Expected Exchange Rates

It is common practice, in some valuation practices, to forecast cash flows in a base currency (even if it is not the currency that you plan to use to estimate your discount rate) and then convert into your desired currency, using expected exchange rates. Thus, a Brazilian analyst who wants to value a Brazilian company in US dollars may estimate expected cash flows in nominal $R first and then convert these cash flow into US $, using an $R/US $ exchange rate. The big estimation question then becomes how best to estimate expected exchange rates and there are three choices.

1. Use the currency exchange rate: The first one, especially in the absence of futures or forward markets, is to use the current exchange rate to convert all future cash flows. This will result in an erroneous value for a simple reason: it creates an inflation mismatch. If, for instance, the expected inflation rate in $R in 9.5% and in US$ is 1.5%, you will significantly over value your company with this approach, because you have effectively built into a 9.5% inflation rate into your cash flows (by using a constant exchange rate) and a 1.5% inflation rate into your discount rate (since you are estimating it in US dollars).
2. Use futures and forward market exchange rates: This is more defensible but only if you then extract risk free rates from these same futures/forward market prices. (This will require that you assume interest rate parity in exchange rates and derive the interest rate in $R from the $R/US$ forward rate). In addition, in many emerging market currencies, the forward and futures markets tend to be operational only at the short end of the maturity spectrum, i.e., you can get 1-year forward rates but not 10-year rates.
3. Use purchasing power parity: With purchasing power parity, the expected exchange rates are driven by differential inflation in the currencies in question. Thus, if purchasing power parity holds and the inflation rates are 9.5% in $R and 1.5% in US$, the $R will depreciate roughly 8% every year. While I am sure that you can find substantial evidence of deviation from purchasing power parity for short or even extended periods, here is why I continue to stick with it in valuation. By bringing in the differential inflation into both your cash flows and the discount rate, it cancels out its effect and thus makes it less critical that you get the inflation numbers right. Put differently, you can under or over estimate inflation in $R (or US $) and it will have no effect on your value.

Currencies and Value

If you can make it through the minefields to estimate cash flows and discount rates consistently, i.e., have the same expected inflation rate in both inputs, the value of a company or a capital investment should be currency invariant. In other words, if you value Tata Motors in Indian rupees, you should get the same value for the company, if you value it entirely in US dollars. If you don't get the same value, I would argue that the difference comes from one or two sources:

• Inflation inconsistencies: It is stemming from inconsistencies in the way that you have dealt with inflation in different currencies, since a company's value should come from its fundamentals and not from which currency you chose to evaluate it in.
• Currency views: You have built in a currency view into your company valuation. Thus, if you assume that the $R will strengthen against the US dollar in the next 5 years, when estimating cash flows, notwithstanding the higher inflation rate, you will find your company to be under valued, when you value it in $R. If that is the case, my suggestion to you would be to just buy currency futures or options, since you are making a bet on the currency, not the company.

The bottom line is that your currency choice should neither make nor break your valuation. A well-run company that takes good investments should stay valuable, whether I value it in US dollars, Euros, Yen or Rubles, just as a badly run or risky company will have a low value, no matter what currency I value it in.

Currency Risk

When working with cash flows in a foreign currency, it is understandable that analysts worry about currency risk, though their measurement of and prescriptions for that risk are often misplaced. First, it is not the fact that exchange rates change over time that creates risk, it is that they change in unexpected ways. Thus, if the Brazilian Reai depreciates over the next five years in line with the expectations, based upon differential inflation, there is no risk, but if it depreciates less or more, that is risk. Second, even allowing for the fact that there is currency risk in investments in foreign markets, it is not clear that analysts should be adjusting value for that risk, especially if exchange rate risk is diversifiable to investors in the companies making these investments. If this is the case, you are best served forecasting expected cash flows (using expected exchange rates) and not adjusting discount rates for additional currency risk.

It is true that currency and country risk tend to be correlated and that countries with high country risk also tend to have the most volatile currencies. If so, the discount rates will be higher for investments in these countries but that augmentation is attributable to the country risk, not currency risk.

Currency Rules for the Road

It is easy to get entangled in the web of currency effects and lose sight of your quest for value, but here are few rules that I think may help you avoid distractions.

1. Currencies are measurement mechanisms, not value drivers: As I write this post, it is a hot day in New York, with temperatures hitting 95 degrees in fahrenheit. Restating that temperature as 35 degrees celsius may make it seem cooler (it is after all a lower number) but does not alter the reality that I will be sweating the minute that I step out of my office. In the same vein, if I value an Argentine company in a risky business, converting its cash flows from Argentine pesos to US dollars will not make it less risky or less exposed to Argentine country risk.
2. Pick a currency and stick with it: The good news is that if your valuations are currency invariant, all you have to do is pick one currency (preferably one that you are comfortable with) and stick with it through your entire analysis.
3. Make your inflation assumptions explicit: While this may cost you some time and effort along the way, it is best to be explicit about what inflation you are assuming, especially when you estimate cash flows or exchange rates, to make sure that it matches the inflation assumptions that you may be building into your discount rates,
4. Separate your currency views from your company valuations: It is perfectly reasonable to have views on currency movements in the future but you should separate your currency views from your company valuations. If you do not, it will be impossible for those using your valuations to determine whether your judgments about valuation are based upon what you think about the company or what you feel about the currency. It is this separation argument that is my rationale for sticking with much maligned purchasing power parity in estimating future exchange rates.
5. You can run, but you cannot hide: If inflation is high and volatile in your local currency, it is easy to see why you may prefer working with a different, more stable currency. It is the reason why so much valuation and investment analysis in Latin America was done in US dollars. The bad news, though, is that while switching to US dollars may help you avoid dealing with inflation in your discount rate, you will have to deal with it in your cash flows (where you will be called upon to forecast exchange rates).

Paper to read:
My paper on country risk (July 2015)

Data attachment:
1. Risk free rates in different currencies (July 2015)
2. Inflation rates, by country (July 2015)

Pearson PLC, the British publishing/education company, has been busy this summer, shedding itself of its ownership in two iconic media investments, the Financial Times and the Economist. On July 23, 2015, it sold its stake in the Financial Times for $1.3 billion to Nikkei, the Japanese media company, after flirting with Bloomberg, Reuters and Axel Springer. It followed up by selling its 50% stake in the Economist for $738 million, with 38% going to Exor, the investment vehicle for the Agnelli family, and the remaining 12% being purchased by the Economist Group itself.

The motive for the divestitures seems to be a desire on the part of Pearson to stay focused on the education business but what caught my eye was the description of both the Financial Times and the Economist as "trophy" assets, a characterization that almost invariably accompanies an inability on the part of analysts to explain the prices paid by the acquirer, with conventional business metrics (earnings, cash flows, revenues etc.).

What is a trophy asset?

My first task in this analysis was to find other cases where the term was used and I found that its use spreads across asset classes. For instance, it seems to be commonplace in real estate transactions like this one, where high-profile properties are being acquired. As in the stories about the Economist and the Financial times, it seems to also be used in the context of media properties that have a long and storied tradition, like the Washington Post and the Boston Globe. In the last few years, sports franchises have increasingly made the list as well, as billionaires bid up their prices for these franchises. I have seen it used in the context of natural resources, with some mines and reserves being categorized as trophy assets for mining companies. While this is a diverse list, here are some of what they share in common:

1. They are unique or rare: The rarity can be the result of natural scarcity (mining resources or an island in Hawaii), history (a newspaper that has survived a hundred years) or regulation/restriction (professional sports leagues restrict the creation of new franchises).
2. They have name recognition: For the most part, trophy assets have name recognition that they acquire either because they have been around for a long time, are in the news or have wide following.
3. They are cash flow generating businesses or investments: In contrast with collectibles and fine art, trophy assets are generally cash flow generating and can be valued as conventional assets/businesses.

There is undoubtedly both a subjective and a negative component to the "trophy asset" label. The subjective component lies in how "rare" is defined, since some seem to define it more stringently than others. The negative aspect of labeling an asset as a trophy asset is that the buyer is perceived as paying a premium for the asset. Thus, an asset is more likely to be labeled as a trophy asset, when the buyer is a wealthy individual, driven more by ego and less by business reasons in making that investment.

Valuing a trophy asset

Rather than take it as a given that buyers overpay for trophy assets, let us look at the possibility that these assets are being acquired for their value rather than their glamor. We have the full financial statements for the Economist but only partial estimates for the Financial Times, and I have used this information to estimate base values for the two assets:

Thus, based on the earnings power in the two assets and low growth rates, reflecting their recent static history, the estimated value for the Economist is about PS800 million and the Financial Times is worth PS410 million. I will label these values in this table as the status quo estimates, since they reflect the ways in these media names are managed currently. While you could take issue with some of my assumptions about both properties, it seems to me that Nikkei's acquisition price (PS844 million) for the Financial Times represents a much larger premium over value than Exor's acquisition of the Economist Group for PS952 million. Does that imply that Nikkei is paying a trophy asset premium for the Financial Times? Perhaps, but there are three other value possibilities that have to be considered.

1. Inefficiently utilized: If a trophy asset is under utilized or inefficiently run, a buyer who can use the asset to its full potential will pay a premium over the value estimated using status quo numbers. That is difficult to see in the acquisition of the Economist stake, at least to the Agnellis, since the interest is a non-controlling one (with voting rights restricted to 20%), suggesting that the acquirer of the stake cannot change the way the Economist is run. With the Financial Times, the possibilities are greater, since there are some who believe that the Pearson Group has not invested as much as it could have to increase the paper's US presence.
2. Synergy benefits to another business: If the buyer of the trophy asset is another business, it is possible that the trophy asset can be utilized to increase cash flows and value at the acquiring business. The value of those incremental cash flows, which can be labeled synergy, can be the basis for a premium over the status quo value. With the Nikkei acquisition of the Financial Times, this is a possibility, especially if growth in Asia is being targeted. With the Agnelli acquisition of the Economist, it is difficult to see this as a rationale since Exor is an investment holding company, not an operating business.
3. Optionality: There is a third possibility and it relates to other aspects of the business that currently may not be generating earnings but could, if technology or markets change. With both the Economist and the Financial Times, the digital versions of the publications in conjunction with large, rich and loyal reader bases offer tantalizing possibilities for future revenues. That option value may justify paying a premium over intrinsic value. In fact, at the risk of playing the pricing game, note that you are acquiring the Economist at roughly the same price that investors paid for Buzzfeed, a purely digital property with a fraction of its history and content.

With the Financial Times, adding these factors into the equation reinforces the point that the price paid by Nikkei can be justified with conventional value measures. With the Economist, and especially with the Exor acquisition, it does look like the buyers are paying a premium over value.

Pricing a trophy asset

As many of you who read my blog know, I have a fetish when it comes to differentiating between the value of an asset and its price. If value is a function of the cash flows from, growth in and risk of a business (estimated using intrinsic valuation models), price is determined by demand and supply and driven often by mood and momentum. If "trophy assets" are sought after by buyers just because they are rare and have name recognition, it is entirely possible that the pricing process can yield a number (price) very different from that delivered by the value process. In particular, the more sought after the trophy asset, the greater will be the premium that buyers are willing to pay (price) over value.

In June 2014, when Steve Ballmer bid $2 billion to buy the Los Angeles Clippers, I tried first explaining his bid by valuing the Clippers as a business. Even my most optimistic estimates of earnings and cash flows at the franchise generated a value of $1.2 billion for the franchise, leading me to conclude that Ballmer was paying the excess amount ($800 million) for an expensive play toy. While it is possible that the same motivations may be driving John Elkann, the scion of the Agnelli family and chairs Exor, in his acquisition of the Economist, I hope that Nikkei, a privately held business, is not paying for an expensive toy.

I am not arguing that paying this price premium is irrational or foolish. Far from it! First, it is possible that the emotional dividends that you receive from owning a trophy asset make up for the higher price up front. After all, Steve Ballmer's friends are likely to be much more excited about being invited to have a ring side view of a Clippers game than watch Microsoft introduce Windows 10. Second, paying a premium over value does not preclude you from generating nosebleed returns from your investment, if you can find other buyers who are willing to pay even bigger premiums to take these trophy assets of your hands. In fact, many sports franchise buyers in the last decade who were viewed as paying nosebleed prices for their acquisitions have been able to sell them to new buyers for even higher prices.

Implications

I tend to be skeptical of when an assets is casually labeled as a trophy asset, since it the labeling allows us to categorize its buyers as driven by non-financial considerations, without having to back up that contention. While both the Economist and the Financial Times have been labeled trophy assets, I think we have to hold back on that judgment, especially with the latter, to see what Nikkei has in mind for its new addition. After all, people were quick to label the acquisition of the Washington Post by Jeff Bezos as a trophy buy, but news stories suggests that there have been major changes at the Post since the deal was completed, which may be laying the foundations for delivering value.

If an asset class becomes a repository for trophy assets, it will attract buyers who will pay for non-economic benefits and the pricing of assets will lose connection to fundamentals. At the MIT Sloan Sports Conference this year, I was on a panel about the "valuation" of sports franchises and I made the argument that wealthy buyers in search of glamorous toys were increasingly changing these markets into pricing markets. In fact, as long as the number of sports franchises is static and the number of billionaires keeps increasing, I see no reason for this trend to stop. So, if the New York Yankees or Real Madrid go on the auction block, be prepared for some jaw-dropping prices for these franchises.

Blog Post Links
Ballmer's Bid for the Clippers: Investment, Trade or Expensive Toy

Spreadsheets
Valuing the Financial Times and the Economist

I have generally steered from using my blog as a vehicle for rants, not because I don't have my share of targets, but because I know that while ranting makes me feel better, it almost always creates more costs than benefits. It is true that I have had tantrums (mini-rants) about the practice of adding back stock-based compensation to EBITDA or expensing R&D to get to earnings, but the targets of those tend to be harmless. After all, what can sell-side Equity Research Analysts or accountants collectively do to retaliate? Refuse to send me their buy and sell recommendations? Threaten me with gang-audits?

This post is an exception, because the target of the rant is China, a much bigger and more powerful adversary than those in my mini-rants, and it is only fair that I let you know my priors before you read this post. First, I am hopelessly biased against the Chinese government. I believe that its reputation for efficiency and economic stewardship is inflated and that its thirst for power and money is soft-pedaled. Second, I know very little about the Chinese economy or its markets, how they operate and what makes them tick. It it true that some of my ignorance stems from the absence of trustworthy information about the economy but a great deal of it comes from not spending any time on the ground in China. So, if you disagree with this post, you have good reason to dismiss it as the rant born of ignorance and bias. If you agree with it, you should be wary for the same reasons.

The Chinese Economic Miracle: Real or Fake?

For the last two decades, the China story has been front and center in global economics, and with good reason. In the graph below, you can see the explosive growth in Chinese GDP, measured in Chinese Yuan and US dollars:

The Chinese economy grew from being the eighth largest in the world in 1994 to the second largest in the world in 2014. It is true that many of the statistics that we use for China come from the Chinese government and there are is reason to question its reliability. In fact, there are some with conspiratorial inclinations who wonder whether the Chinese miracle is a Potemkin village, designed for show. Much as my bias would lead me down this path, there are some realities on the ground that are impossible to ignore:

1. The China growth story is real: Any one who has visited China will tell you that the signs of real growth are around you, especially in urban China. It is not just the physical infrastructure of brand new airports, highways and high-speed trains, but the signs of prosperity among (at least some of) its people. I did my own experiment yesterday that confirmed the reality of Chinese growth. After I woke up to the alarm on my China-made iPhone, I put on my Nike exercise clothes, manufactured in China, slipped on my Asics running shoes, also from China. As I went through the day, it was easier for me to keep track of the things that were not made in China than those that were. Based just on that very unscientific sampling, I am willing to believe that China is the world's manufacturing hub.
2. It has a Beijing puppet-master: To those who celebrate the growth of the Chinese economy as a triumph of free markets, I have to demur. The winners and losers in the Chinese economy are not always its best or most efficient players and investment choices are made by policy makers (or politicians) in Beijing, not by the market. There are those who distrust markets who would view this as good, since markets, at least in their view, are short term, but trusting a group of experts to determine how an economy should evolve can be even more dangerous.
3. It is driven by infrastructure investment, not innovation: The Chinese economy is skilled at copying innovations in other parts of the world, but not particularly imaginative in coming up with its own. It is revealing that the current vision of innovation in China is to have a CEO dress up like Steve Jobs and make an Android phone that looks like the iPhone. Note that this should not be taken as a reflection of the Chinese capacity to be innovative but a direct consequence of centralized policy (see prior point).
4. The China story is now part of every business: In just the last month and a half, I have been in the US, Brazil and India, and can attest to the fact that the China story is now embedded in companies across the globe. In the US, I saw Apple report good earnings and lose $100 billion in market capitalization, with some attributing the drop to disappointing results from China. In Brazil, my Vale valuation rests heavily on how China does in the future, because China accounts for 37% of Vale's revenues and the surge in iron ore prices in the last decade came primarily from Chinese infrastructure investment. In India, I valued Tata Motors, whose acquisition of Jaguar , has made them more of a Chinese company than an Indian one, dependent on the Chinese buying oversized Land Rovers for a significant portion of their profits.
5. It is also a weapon of mass distraction: In a post from a few months ago, I talked about weapons of mass distraction, words that analysts use to induce you to pay premiums for companies and to distract you from specifics. In that post, I highlighted "China" as the ultimate wild card, with mention of exposure to the country operating as an excuse for pushing up the stock price. The problems with wild cards though is that they are unpredictable, and it is entirely possible that the China card may soon become a reason to discount value, as the handwringing about earnings effects and corporate exposures of the China crisis begins.

The Chinese Markets: All Pricing, all the time!

If you have been reading the news for the last few months, which have been about the epic collapse of Chinese stocks, I would not blame you for feeling sorry for investors in the Chinese market. I would suggest that you save your sympathy for more deserving causes, because as with everything else in markets, it depends on your time perspective. In the chart below, I look at three charts that look at the Shanghai Composite over time:

It is undeniable that markets have been melting down since June, with the Shanghai Composite down 32% from its peak on June 12. However, if you had invested in Chinese stock at the start of this year, you have no reason to complain, with a return of 8.44% for the year to date, among the best-performing markets globally. Stepping even further back, if you had invested in Chinese stocks in 2005, you would have earned close to 13$ as an annual return each year, with all the ups and downs in between.

In earlier posts, I have drawn a contrast between valuation and pricing and why a healthy market need both investors (who buy or sell businesses based on their perceptions of the values of these businesses) and traders (who buy and sell assets based on what they think others will pay for them). A market dominated mostly by investors will quickly become illiquid and boring, and ironically reduce the incentives to collect information and value companies. A market dominated by traders will be volatile, with price movements driven by mood, momentum and incremental information, and will be subject to booms and busts. I would characterize the Chinese stock market as a pricing market, where traders rule and investors have long since fled or have been pushed out. While there are some who will attribute this to China being a young financial market, and others to cultural factors, I believe that it is a direct consequence of self-inflicted wounds.

1. Investor restrictions: There is perhaps no more complicated market to trade in than the Chinese markets, with most Chinese companies having multiple classes of shares: Class A shares, and traded primarily on the mainland, denominated in Yuan, Class B shares, denominated in US $, traded on the mainland and Class H shares, traded in Hong Kong, denominated in HK$. The Chinese government imposes tight restrictions on both domestic investors (who can buy and sell class A shares and class B shares, but only if they have legal foreign currency accounts, but cannot trade in class H shares) and foreign investors (who can buy and sell only class B and class H shares). As a consequence of these restrictions, investors are forced into silos, where shares of different classes in the same company can trade at different prices and governments can keep a tight rein on where investors put their money. Note also that the highest profile technology companies in China, like Baidu and Alibaba, create shell entities (variable interest entities or VIEs) and list themselves on the NASDAQ, making them effectively off-limits to domestic investors.
2. Opaque financials and poor corporate governance: While China has moved towards adopting international accounting standards, Chinese companies are not doyens of disclosure, often holding back key information from investors. It is therefore not surprising that almost 10% of all securities class action litigation in the US between 2009 and 2013 was against Chinese companies listed in the US, that variable interest entities hold back key information and that non-Chinese companies like Caterpillar and Lixil have had to write off significant portions of their Chinese investments, as a result of fraud. This non-disclosure problem is twinned with corporate governance concerns at Chinese companies, where shareholders are viewed more as suppliers of capital than as part-owners of the company.
3. Markets as morality plays: The nature of markets is that they go up and down and it is that unpredictability that keeps the balance between investors and traders. In China, the response to up and down markets is asymmetric. Up markets are treated as virtuous and traders who push up stock prices (often based on rumor and greased with leverage) are viewed as "good" investors. Down markets are viewed as an affront to Chinese national interests and not only are there draconian restrictions on bearish investors (restrictions on short selling, trading stops) but investors who sell stock are called traitors, malicious market manipulators or worse. Thus, the same Chinese government that sat on its hands as stock prices surged 60% from January to June has suddenly discovered the dangers of volatility in the last few weeks as markets have given up much of that gain.

The bottom line is that the Chinese government neither understands nor trusts markets, but it needs them and wants to control them. By restricting where investors can put their money, treating short sellers as criminals and market drops as calamities, the Chinese government has created a monster, perhaps the first one that does not respond to its dictates. The current attempt to stop the market collapse, including buying with sovereign funds, putting pressure on portfolio managers, name calling and sloganeering may very well succeed in stopping the bleeding, but the damage has been done.

Moneyball in China

The best cure for bias and ignorance is data and I decided that the first step in ridding myself of my China-phobia would be a look at how Chinese stocks are being priced in the market today. The essence of value investing is that at the right price, any company (including a Chinese company with opaque financials and non-existent corporate governance) can be a good investment and it is possible that the drop in stock prices in the last few months has made Chinese stocks attractive enough for the rest of us.

To make these comparisons, I used the market price data as of August 19, 2015, to estimate market capitalization and enterprise values. For the accounting data, I used the numbers from the trailing 12 months, generally the 12 months ending mid-year 2015, for most companies. The first comparison was on pricing multiples:

I compared China with India, Brazil and Russia, the three other countries that have been lumped together (awkwardly, in my view) as the BRIC, as well as with the rest of the emerging markets. For comparisons, I also looked at the US and the rest of the developed markets (where I included Japan, Western Europe, Australia, Canada and New Zealand). In spite of the drop in stock prices in the last few months, Chinese stocks are collectively more expensive than stocks anywhere else in the world.

To measure the profitability of Chinese companies, I looked at three measures of margin (EBITDA, Operating Income and Net Income) and three measures of return (Return on Equity and Return on Invested Capital):

Chinese companies lag the rest of the world, when it comes to EBITDA and operating margins, but do better than other emerging market companies on net margins. On returns on equity and invested capital, Chinese companies are more profitable than Brazilian companies (reflecting the economic downturn in Brazil in the last year) but are pretty much on par with the rest of the world.

One reason for the superior net margins at Chinese companies is that they tend to borrow less than companies elsewhere in the world, perhaps the only bright light in these comparisons.

That may be at odds with some of what you may be reading about leverage in China, but it looks like the debt in China is either more in the hands of local governments or is off balance sheet.

Finally, if the straw that you are grasping for is higher growth in China, there is some backing for it when you compare growth rates across companies, but only in analyst expectations, rather than in growth delivered:

It is true that this market-level look at China may be missing bargains at the sector level and to remedy that, I looked at PE ratios and EV/EBITDA multiples regionally, by industry grouping. The industry-average values, classified by region, can be downloaded here, but across the ninety five industry groupings, Chinese companies have the highest PE ratios in the world in fifty and the highest EV/EBITDA multiples in fifty eight. You could dig even deeper and look at company-level data and you are welcome to do so, using the complete dataset here.

Overall, I am hard pressed to make a case for investing in Chinese stocks, if you have a choice of investing in other markets, even after the market drop of the last few months. If you are a domestic investor in China, your choices are more restricted, and you may very well be forced to stay in this market. It is interesting that India and China, two markets that restrict domestic investors from investing outside the country, are the two most richly priced.

Conclusion

As I confessed up front, I am not a China hand and don't claim any macro or market forecasting skills, but my experience with company valuation and pricing lead me to make the following predictions for China.

1. Slower real growth: If I were a betting man, I would be willing to take a wager that the expected real growth rate in the Chinese economy will be closer to 5% a year for the next decade than to the double-digit growth that we have been programmed to expect. That may strike you as pessimistic, after the growth of the last two decades, but just as size eventually catches up with companies, the Chinese economy is getting too big to grow at the rates of yesteryear. The question, for me, is not whether this will happen but how the Chinese government will deal with the lower growth. While the sensible option is to accept reality and plan for lower real growth, I fear that the need to maintain appearances will lead to a cooking of the economic books, in which case we will have an number-fixing scandal of monumental proportions.
2. More pricing ahead: I don't see much hope that investors will be welcomed back into Chinese markets any time soon. So, even if this market shakeup drives some of traders out of the game, investors motivated by value will be reluctant to step in, if the government continues to make markets into morality plays. As long as the market continues to be a pricing game, the price moves in the market will have little do with fundamentals. As a consequence, I would suggest that you ignore almost all attempts by market experts to explain what is happening in Chinese markets with economic stories.
3. Buyer beware: If you are drawn to Chinese markets (like moths to a flame), here is my advice for what it is worth. If you are an investor, you need to look past the hype and value companies, opacity and complexity notwithstanding, and be a realist when it comes to corporate governance. If you are a trader, this is a momentum game and if you can get ahead of momentum shifts, you will make money. If your bet is on the downside, just be ready to be maligned, abused or worse.

I understand why corporate chieftains and heads of government are unwilling to speak openly about the Chinese government, given how much of their own economic prosperity rests on maintaining good relations. Financial markets don't have such qualms and they are delivering their message to Beijing clearly and decisively. Let's hope someone is listening!

Attachments
1. Industry-average PE and EV/EBITDA, by sector
2. Chinese Company-level data, Multiples and Fundamentals

It is almost September and as the academic clock resets for a new year, I get ready to teach a new valuation class. With three hundred registered students, it is about as diverse a class as any I have every taught, with a mix of full-time and part-time MBA students, law and engineering graduate students and a few dozen undergraduates. And with a market meltdown framing discussions, it will be interesting to see how the class plays out. As always, I cannot wait for the class to start and as I have, each semester, for the last few years, I invite you to follow the class, if you are so inclined.

Setting the table

Valuation is an intimidating title for a class, stirring up visions (and nightmares) about spreadsheets, accounting statements and financial theory. This may be the default version of the class and it serves experts in the topic well to preserve this air of mystery and intimidation. I have neither the expertise nor the desire to teach such a class, and I hope that you will not only take my class, no matter what your background and experience, but that you will also learn to enjoy valuation as much as I do. The best way for me to start describing my class is to tell you what it is not about, rather than what it covers. So, here we go:

1. It is not an accounting class: Much of the raw data in my valuations comes from accounting statements, but once I get that raw data, I lose interest in the rest of the accounting details. In fact, one of my first in-practice webcasts (short webcasts about practical issues in valuation) uses the Procter and Gamble 10k to illustrate how little of a typical accounting filing gets used in valuation and how much is irrelevant or useless. I admire people who can forecast our full financial statements (income statements, balance sheets and cash flow statements) decades out, but I have never ever felt the urge to do so and I am not sure that I have the accounting skills to even do so.
2. It is not a modeling class: As someone who did his first valuation on an old fashioned columned paper sheet with a calculator, I have mixed feelings about spreadsheets, in general, and Microsoft Excel, in particular. I like the time that I save in computational details, but I have to weigh that against the time I lose, playing pointless what-if games with the data that I would never have considered in my calculator days. I admire Excel Ninjas but I have also seen what happens when analysts become the spreadsheet's tools, rather than the other way around. Needless to say, I have never taught a session (let alone a class) built around Excel spreadsheets, though I have no qualms about using one to illustrate fundamental valuation principles.
3. It is not a financial theory class: To be able to teach this class at a research university, I had to go through the rites of passage of a Finance doctoral student, traversing the path that finance has followed, starting with Harry Markowitz and modern portfolio theory, moving through its Greek phase (with alphas and betas dominating the conversation first and then leading on to the expropriation of the rest of the Greek alphabet by the options theorists) to the counter-revolutionaries of behavioral finance. Unlike some who make you choose whether you are for financial theory or against it, I view it as a buffet, where I can partake on the portions of the theory that I find useful and leave behind that which I do not. In my valuation class, in particular, I would be surprised if I spent more than 5% of my time on financial theory, and if I do, it is only because I am trying to get to some place more interesting.

Now that I have established what the class is about, let me lay out the five themes around which this class is built.

1. Valuation is a craft, not an art or a science: I start my class with a question, "Is valuation an art or a science?", a trick since the answer, in my view, is neither. Unlike physics and mathematics, indisputably sciences with immutable laws, valuation has principles but none that meet the precision threshold of a science. At the other extreme, valuation is not an art, where your creative instincts can guide you to wherever you want to go and geniuses can make up their own rules. I believe that valuation is a craft, akin to cooking and carpentry, and that you learn what works and what does not by doing it, not by reading or listening to others talk about it. That is the reason that each week during the course of the semester, I post my valuation of a company, with a Google shared spreadsheet for everyone in the class to try their hand at valuing the same company and coming to a very different conclusion than I do.
2. Valuing an asset is different from pricing it: I will not bore you by repeating this distinction that I drew first in this post but have returned to over and over again. It is my belief that much of what passes for valuation, in practice, is really pricing, sometimes disguised as valuation and sometimes not, but I also think that there is nothing wrong with pricing an asset, if that is what your job entails. Thus, though the bulk of this class is built around intrinsic value and its determinants, a significant portion of the class is dedicated to better pricing techniques, through the judicious use of multiples, comparable assets and statistics.
3. Anything can be priced and most almost anything can be valued: This may be stubborn side speaking, but I have always believed that you can value any cash-flow generating asset (as I have attempted to, in these posts on valuing tracking stock on a professional athlete, a sports team, a trophy asset and young companies) and that you can price any asset (as I tried to to, in these posts on Gold and Bitcoins). While this class is centered around valuing publicly traded companies, I deviate from that script often enough, that by the end of the class, you should be able to value and price any asset.
4. Valuation = Story + Numbers: As readers of this blog, you have heard me get on the soapbox often enough, but to me the essence of valuation is connecting stories to numbers. As I noted in this most recent post of mine, this requires me to push people out of their comfort zones, encouraging numbers people to tell more stories and stories people to work more with numbers. No matter how far on either end of the numbers/ story spectrum you are, I think that no one is beyond reach.
5. Valuation without action is pointless: I have never felt the need to use a case study in my valuation class or value a widget company in my class, because I not only find valuing real companies in real time more interesting, but I can act on my own valuations and I usually do, though not always with conviction. Investing requires faith in both your capacity to value companies and in markets correcting over time and I try to let people see both the source of my faith and challenges to that faith.

   I did put together a short (about two minutes) YouTube video of my class that summarize my perspective on this class.

So, both number crunchers and story tellers, welcome to the class and we can learn from each other!

Prepping for the class

As a realist, there are a few skills that will stand you in good stead in this class and none of these skills are difficult to acquire.

1. Read financial statements: For better or worse, our raw data comes from accounting statements and you need to be able to navigate your way through these statements. If you have a tough time deciphering the difference between gross, operating and net income, and don't quite understand what goes into book value of equity, you will have a tough time valuing companies. Don't remember your accounting classes? Don't want to go back there? Never fear! I have a primer on accounting that takes you through the absolute basics (which is about all I know anyway) and you can get to it by clicking on this link.
2. Understand basic statistics: Statistics, I was taught in my first class, is designed to help us make sense of large and contradictory data. Since that is precisely our problem in pricing assets today, i.e., that we have too much data pulling us in too many directions, it may be time to dust off that statistics book (I hope that you did not sell it back or burn it after your last statistics class) and reacquaint yourself with simple statistics. So, start with the averages, medians and standard deviations, move on to correlations and regressions and if you can handle it, to statistical distributions. If you are lost, try this link for my statistics primer.
3. Get comfortable with rudimentary finance: I have always found it unfair that to take some classes, you have to take the equivalent of a lifetime in pre-requisites. While having taken a corporate finance class eases the way in valuation, it is not required, nor is any other finance course. That said, your life will be easier if you have nailed down the basics of time value of money and computing present value, as well as understand the roots of modern portfolio theory, even if you don 't quite get the specifics. This link has my time value of money primer.

Getting down to Specifics

It's taken me a while to get to specifics, but the class starts on September 2, 2015 and classes are every Monday and Wednesday from 10.30 am -11.50 am (with Sept 7, 14 and 23 being holidays) until December 14. The calendar for the class is available at this link. The class content will follow a familiar path, starting with a big picture perspective on valuing/pricing, followed by intrinsic valuation (DCF), relative valuation (pricing and multiples), asset-based valuation (accounting, liquidation & sum of the parts) and it will end with real options. There will be two add-on sessions on acquisition valuation and value enhancement.

If you are one of the 300 registered in the class, I hope to see you in class. If not, the classes will be recorded and webcast, usually by the end of each session day, and there are three forums you can use to follow the class:

1. My website: Everything I do in this class will be accessible on this page for the class. As you will notice on the page, you can not only access the webcasts for the lectures, but you can download the lecture notes, try your hand at the valuations of the week and even take quizzes/exams (though you have to grade them yourself). If you want, you can read the emails that I send to the class at this link.
2. iTunes U: This has become one of my favorite platforms for delivering my class and it works flawlessly, if you have an Apple device, with an iPad providing a much better experience than an iPhone. (You have to download the iTunes U app, but it is free and the learning curve is barely uphill.) However, you can tweak it to work on an Android, with an add-on app. This semester's version will be available at this link.
3. YouTube: This was my add-on platform last semester and while it was never intended for delivering full classes, it worked surprisingly well. The webcasts come naturally to it, though the 80 minutes is a stretch, but I will add on the presentation material and the post-class tests to the webcasts to supplement them. This semester, the lectures and supporting material will be found at this channel.

Alternate Pathways

This is not the first time that I have put my classes online and this may not be the first time that you have thought about taking this particular class. As with other online classes, I know that life gets in the way, with family and work commitments taking priority, as they should, over an online valuation class that provides no credit or certification. You can follow one of the following four paths, each requiring more time and brain commitment than the prior one:

1. Watch an occasional lecture or lectures: Rather than watch all 26 lectures, you can pick and choose a few on the topics that interest you the most. This strategy works best for those who cannot commit the time and/or are already experienced enough in valuation that they need just a brushing up of skill sets.
2. Watch every lecture, do post class tests/solutions: You could watch every lecture, a significant time commitment at 80 minutes apiece, and do just the post-class tests (designed to take about 5-10 minutes). Remember that you don't have to take this in real time, since the course will stay online for at least a year.
3. Watch lectures and take quizzes/exam: In addition to watching the lectures, you can put your knowledge to the test and take the quizzes and final exam. I will post my solutions with a grading template and you can grade yourself (My advice: Be an easy grader!). Since the exams are all open-book, open-notes all you have to do is honor the time constraint (30 minutes for quizzes, 2 hours for the final).
4. Watch lectures, take quizzes exam & value a company: In addition to doing all of the tasks in the prior path, you also pick a company to value (just as everyone else in my class will be) and try to apply what you learn in the class in that valuation. Unfortunately, there is little chance that I can offer you the feedback that I offer to those in my class, but I will try to answer a question or two, if you are stuck, and will provide my feedback template, when the time comes due.

If all of these pathways all sound like too much work/time commitment and/or watching 80 minute videos of valuation lectures on your phone or tablet is not your idea of fun, I do have an alternative. Try my online valuation class, where the sessions are about 10-15 minutes apiece, on my website, YouTube or iTunes U.

Pass on it or pass it on!

If you try the class and don't like it, I will not be offended and I am sure that you will find a better use for your time. If you try the class and you like it, I would like something in return. Please pass on a bit of what you know or have learned to at least one other person, and perhaps more. Knowledge is one of the few things in life that we can share, without being left poorer for the sharing, and while the return on this investment will be not be financial, the emotional dividends will make it worthwhile.

Attachments
Preview of class (YouTube)
Links
Webpage for the class (on my website)
Webpage for Valuation Online class (short sessions)
iTunes U for the upcoming class
iTunes U for the Valuation Online class (short sessions)
YouTube for the upcoming class
YouTube for the Valuation Online class (short sessions)