Beta
As for beta, it is intended to reveal what part of any “market risk premium” is borne by a particular company’s stock. Beta determines this component of the discount rate estimate for a company’s equity by using various assumptions to compare its stock price gyrations with those of the overall stock market or a market index such as the S&P 500.
A stock whose price is more volatile than the market’s is seen as “riskier” than one whose price gyrates less than the market as a whole. Multiplying this measure of price volatility by a “market risk premium” theoretically expresses the differential risk the particular stock poses. The result is added to the risk-free rate to give a discount rate.
Beta is only potentially useful if stock prices of the subject company and of all components of the market or market index result from investor behaviour that is, collectively, rational. Such conditions of “market efficiency” might substantially occur for some companies in some cases and for some markets or some market segments at some time.
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Wednesday 14 January 2009
Portfolio Theory: Market Risk Premiums
Market Risk Premiums
The variables also are integrated so that changes in one may indicate modification of another. For example, increases in the risk-free rate entail decreases in the market risk premium (the latter supposedly measures the difference between the risk-free rate and the expected return on common stocks). The need for estimation judgment, and the complex interrelationship among these variables, means that prudent analysis draws on multiple reasonable data points (by applying alternative methods and taking alternative measures of each variable).
The “market risk premium: is a guess based on history of what special inducements it takes to attract investors into stocks rather than buying U.S. Treasury securities or alternative investments. The idea is that investors must be given special compensation to bear the special risks of stocks or else they will not invest in them.
Data on Market Risk Premiums
Common practice is to consult data books published by leading economists, such as the one published by a firm run by Yale University professor Roger Ibbotson called the Ibbotson & Sinquefeld Yearbook. The harder way is doing it yourself, which is virtually impossible for non-professionals. But it is useful to understand why, so here goes.
Market risk premium data can be calculated up-to-the-minute at any time. Three crucial assumptions must be made to estimate the market risk premium.
1. First, the estimator must choose either historical data or some measure of future performance.
2. Second, one must define a “market” for the measure, such as the Standard & Poor’s 500, the New York Stock Exchange as a whole, or some other index.
3. Third, the estimate is based on a specified time period.
Alternatives include the period from the late 1800s (when market data were first recorded) to the time of valuation interest; from 1926 (when the University of Chicago began a database, thought to have the virtue of including a full business cycle before the 1929 market crash) to the time of valuation interest; for the 30-year period before the time of valuation interest (reflecting business cycles exhibiting more relevant business and financial risks and factors); or for specific environments being analysed, such as the early 2000s.
Challenges in using "market risk premium"
Seizing on a measure of the “market risk premium” became acutely tricky during the late 1990s because any such thing seemed to be evaporating. Any premium that once existed – e.g., in the period before 1990 – dwindled toward zero, as the most powerful bull market in world history produced investors who needed no inducements to join. Even staunch devotees of modern finance theory lamented the declining usefulness of “market risk premium” device during the 1990s.
Despite this well-known fact even among its fans, analysts sticking with this learning adhere to favourite benchmarks, such as 9 percent based on long-run historical returns on stocks dating back to the 1930s. Others respond to their gut sense that this is almost certainly wrong, and opt instead for rates of 7 percent, 5 percent, or less. Some believe it was moving towards zero in the late 1990s.
A group of the country’s leading financial economists assembled in mid-2000 to offer their measurements of the market risk premium. Eleven participated. Their estimates of the risk premium were: 0, 1-2, 3, 3-4, 4, 6, 6, and 8.1 percent, with three refusing to venture a guess giv en the concept’s indefiniteness and uncertain reliability.
Reasons for the decline or evaporation include powerful forces, such as U.S. investors became more long-term oriented, U.S. business efficiency heightened, fiscal policies and monetary management improved, capitalism spread globally, wealth increased, and business fundamentals exhibited less volatility.
Also read:
The variables also are integrated so that changes in one may indicate modification of another. For example, increases in the risk-free rate entail decreases in the market risk premium (the latter supposedly measures the difference between the risk-free rate and the expected return on common stocks). The need for estimation judgment, and the complex interrelationship among these variables, means that prudent analysis draws on multiple reasonable data points (by applying alternative methods and taking alternative measures of each variable).
The “market risk premium: is a guess based on history of what special inducements it takes to attract investors into stocks rather than buying U.S. Treasury securities or alternative investments. The idea is that investors must be given special compensation to bear the special risks of stocks or else they will not invest in them.
Data on Market Risk Premiums
Common practice is to consult data books published by leading economists, such as the one published by a firm run by Yale University professor Roger Ibbotson called the Ibbotson & Sinquefeld Yearbook. The harder way is doing it yourself, which is virtually impossible for non-professionals. But it is useful to understand why, so here goes.
Market risk premium data can be calculated up-to-the-minute at any time. Three crucial assumptions must be made to estimate the market risk premium.
1. First, the estimator must choose either historical data or some measure of future performance.
2. Second, one must define a “market” for the measure, such as the Standard & Poor’s 500, the New York Stock Exchange as a whole, or some other index.
3. Third, the estimate is based on a specified time period.
Alternatives include the period from the late 1800s (when market data were first recorded) to the time of valuation interest; from 1926 (when the University of Chicago began a database, thought to have the virtue of including a full business cycle before the 1929 market crash) to the time of valuation interest; for the 30-year period before the time of valuation interest (reflecting business cycles exhibiting more relevant business and financial risks and factors); or for specific environments being analysed, such as the early 2000s.
Challenges in using "market risk premium"
Seizing on a measure of the “market risk premium” became acutely tricky during the late 1990s because any such thing seemed to be evaporating. Any premium that once existed – e.g., in the period before 1990 – dwindled toward zero, as the most powerful bull market in world history produced investors who needed no inducements to join. Even staunch devotees of modern finance theory lamented the declining usefulness of “market risk premium” device during the 1990s.
Despite this well-known fact even among its fans, analysts sticking with this learning adhere to favourite benchmarks, such as 9 percent based on long-run historical returns on stocks dating back to the 1930s. Others respond to their gut sense that this is almost certainly wrong, and opt instead for rates of 7 percent, 5 percent, or less. Some believe it was moving towards zero in the late 1990s.
A group of the country’s leading financial economists assembled in mid-2000 to offer their measurements of the market risk premium. Eleven participated. Their estimates of the risk premium were: 0, 1-2, 3, 3-4, 4, 6, 6, and 8.1 percent, with three refusing to venture a guess giv en the concept’s indefiniteness and uncertain reliability.
Reasons for the decline or evaporation include powerful forces, such as U.S. investors became more long-term oriented, U.S. business efficiency heightened, fiscal policies and monetary management improved, capitalism spread globally, wealth increased, and business fundamentals exhibited less volatility.
Also read:
Modern Portfolio Theory
PORTFOLIO THEORY APPROACH: BETA AND PREMIUMS
Modern finance theory uses the “capital asset pricing model” (CAPM) to estimate discount rates for equities.
Using CAPM requires estimating two inputs in addition to a risk-free rate. These are a “market risk premium” and “beta,” a measure of stock price volatility seen by backers as a risk indicator.
The mistake some analysts make is to assume that there is a single accurate data point for each of these inputs. However, each of these variables is an estimate requiring judgment.
Also read:
Modern finance theory uses the “capital asset pricing model” (CAPM) to estimate discount rates for equities.
Using CAPM requires estimating two inputs in addition to a risk-free rate. These are a “market risk premium” and “beta,” a measure of stock price volatility seen by backers as a risk indicator.
The mistake some analysts make is to assume that there is a single accurate data point for each of these inputs. However, each of these variables is an estimate requiring judgment.
Also read:
Tuesday 13 January 2009
Traditional Discount rate or WACC (II)
Traditional Method: Discount rate or Weighted average cost of capital (WACC)
Most generally, the practice is to estimate the returns investors are insisting upon for companies bearing like qualities (in terms of industry, capital structure, maturation, size, competitive outlook, and so on).
Most generally, the practice is to estimate the returns investors are insisting upon for companies bearing like qualities (in terms of industry, capital structure, maturation, size, competitive outlook, and so on).
- For companies with long records of sustained earnings, low rates are indicated, perhaps just a few points above the risk-free rate.
- For newer, more volatile operations, a larger premium is required.
The estimate requires exercising practical judgment based on learning what compensation is given to investors bearing comparable business and financial risks.
- What special business and financial risk do common stockholders face?
- What are the debt levels?
- What is the likelihood that debt investors would be paid before them or that high debt would throw the company into bankruptcy?
- What is the company’s financial strength and industry leadership?
- Is its market expanding or contracting?
- Is there room for growth that will add value?
In short, assessing risk relevant to the discount rate implicates the same questions value investors ask when defining circles of competence.
Value investors see risk as arising from either
- deterioration in an investment’s business value or
- overpaying for it in the first place.
Overpayment can result from inadequate or mistaken analysis of these questions. The possibility of misrelating price and value implies a commonsense point: High stock prices compared to earnings make for high-risk investments.
A value investor’s conception of risk differs from that of modern finance theory, today’s dominant model for defining risk. This theory measures risk using market price fluctuations as proxies for underlying business-value changes. While the exercise appears precisely scientific, in fact it is as judgment-laden as the traditional method. It also defies common sense: In this model, the fact that a stock price is high or low compared to earnings has no bearing on risk. Despite these weaknesses, the widespread use of this model warrants summarizing it as a contrast to value investing.
Also read:
- Understanding Discount Rates
- Risk-free rate
- Traditional Method: Discount rate or WACC (I)
- Traditional Method: Discount rate or WACC (II)
- Modern Portfolio Theory
- Portfolio Theory: Market Risk Premiums
- Portfolio Theory: Beta
- Is the market efficient, always?
- Discount Rate Determinations: Summary
Traditional Discount rate or WACC (I)
Traditional Method: Discount rate or Weighted average cost of capital (WACC)
To the risk-free is added an amount reflecting risks associated with a particular investment. This produces the discount rate to apply to determine the present value of an asset.
For a business with debt and equity in its capital structure, this is commonly called the weighted average cost of capital (WACC). It is the proportional cost of a company’s debt, determined by the after-tax interest cost, and the cost of equity, determined by a more judgment –laden but conceptually identical inquiry.
The cost of equity is conceptually identical to the cost of debt because they involve the same question:
The key reference is what other capital market participants are paying investors to attract equity financing form enterprises of comparable risk.
To the risk-free is added an amount reflecting risks associated with a particular investment. This produces the discount rate to apply to determine the present value of an asset.
For a business with debt and equity in its capital structure, this is commonly called the weighted average cost of capital (WACC). It is the proportional cost of a company’s debt, determined by the after-tax interest cost, and the cost of equity, determined by a more judgment –laden but conceptually identical inquiry.
The cost of equity is conceptually identical to the cost of debt because they involve the same question:
- What must the company pay to induce investment, whether from debt lenders or equity holders?
The key reference is what other capital market participants are paying investors to attract equity financing form enterprises of comparable risk.
- To estimate the cost of equity capital for high-risk venture capital projects, for example, one could consult the returns offered by venture capitalists in such enterprises.
- For low-risk enterprises, underwritten secondary public offerings of blue-chip companies can be examined.
Also read:
Risk-free rate
VALUE INVESTING APPROACH TO RISK AND RATES
The “risk-free rate” can be estimated by reference to U.S. government securities, loans investors make to the U.S. Treasury.
The U.S. Treasury is seen as the purest credit risk in the world, committed to paying its debts when due without fail. Hence, yields on U.S. Treasury debt are considered the benchmark for valuing all other assets, including corporate debt and equities.
Corporate debt bears greater risk than U.S. Treasury debt. In corporate bankruptcy, debt is paid before common stock, so the common stock of a company carrying debt bears a greater risk than that debt.
Selecting a risk-free rate requires judgment based on various factors. Such factors include:
Other customs include using 30-year bonds to reflect the long-term character of the investment in a corporation.
When valuing a business as a going concern, following the daily, weekly, or monthly movements in the U.S. Treasury market introduces distorting valuation volatility into the exercise. Business value does not move in tandem with daily or even monthly fluctuations in Treasury rates. Avoiding the sensitivity to short-term fluctuations in treasury rates can be done by averaging rates over the preceding year or so.
To the risk-free is added an amount reflecting risks associated with a particular investment. This produces the discount rate to apply to determine the present value of an asset. For a business with debt and equity in its capital structure, this is commonly called the weighted average cost of capital (WACC).
Also read:
The “risk-free rate” can be estimated by reference to U.S. government securities, loans investors make to the U.S. Treasury.
The U.S. Treasury is seen as the purest credit risk in the world, committed to paying its debts when due without fail. Hence, yields on U.S. Treasury debt are considered the benchmark for valuing all other assets, including corporate debt and equities.
Corporate debt bears greater risk than U.S. Treasury debt. In corporate bankruptcy, debt is paid before common stock, so the common stock of a company carrying debt bears a greater risk than that debt.
Selecting a risk-free rate requires judgment based on various factors. Such factors include:
- bond maturity,
- reference date or time frame, and
- reference source.
Other customs include using 30-year bonds to reflect the long-term character of the investment in a corporation.
When valuing a business as a going concern, following the daily, weekly, or monthly movements in the U.S. Treasury market introduces distorting valuation volatility into the exercise. Business value does not move in tandem with daily or even monthly fluctuations in Treasury rates. Avoiding the sensitivity to short-term fluctuations in treasury rates can be done by averaging rates over the preceding year or so.
To the risk-free is added an amount reflecting risks associated with a particular investment. This produces the discount rate to apply to determine the present value of an asset. For a business with debt and equity in its capital structure, this is commonly called the weighted average cost of capital (WACC).
Also read:
Understanding Discount Rates
Discount Rates
Choosing an appropriate discount rate (or cost of capital) is necessary to determine present value, whether measured by current earnings or a more elaborate discounted cash flow model.
The discount rate must reflect
Choosing an appropriate discount rate (or cost of capital) is necessary to determine present value, whether measured by current earnings or a more elaborate discounted cash flow model.
The discount rate must reflect
- the time value of money and
- the specific risks associated with te individual company.
Equity is riskier than debt, so the discount rate for a given company will be some increment above the prevailing rates at which any debt it has outstanding are being discounted. The challenge is determining how much greater.
Conceptually, think of the discount rate as the rate of return a prudent investor would require for allocating capital to the subject company
A high-risk venture would warrant a proportionately high discount rate; a sure thing, a rate probably equal to the time value of money.
The surest investments in contemporary investing are U.S. government securities. These furnish the risk-free rate.
Appropriate discount rates for most corporate equity will take U.S. government securities as the starting point and add an additional element.
Considered below are two alternative conceptual approaches to thinking about and settling upon an appropriate discount rate,
- one traditional and
- one from modern finance theory.
Also read:
Hazards of the Future and Limitations of DCF
Hazards of the future and limitations of DCF
The process of estimation and discounting is intended to recognize the hazards of the future by incorporating into the cash flow estimates the onslaughts of:
Likewise, the discount rate is intended to capture the effects on capital costs of:
But all these variables are by definition unknown, uncertain, and difficult to quantify. In the math, moreover, tiny differences in the assumptions drive substantial differences in resulting valuations.
Among the largest component of resulting value in this model is the value assigned to the horizon (the perpetuity piece beyond the 5- or 10-year mark). Its derivation is a function of assumed growth rate and assumed cost of capital. At estimates of 5 percent and 10 percent, as noted, the multiple is 20; tweak these and enormous ranges emerge.
Even so, the discounted cash flow valuation model is the most widespread model in contemporary valuation.
Also read:
The process of estimation and discounting is intended to recognize the hazards of the future by incorporating into the cash flow estimates the onslaughts of:
- competition,
- technology,
- patent expiration,
- deregulation,
- globalization, and
- other upheaval.
Likewise, the discount rate is intended to capture the effects on capital costs of:
- long-term financing markets,
- lender appetites for the company’s securities, and all such underlying risks.
But all these variables are by definition unknown, uncertain, and difficult to quantify. In the math, moreover, tiny differences in the assumptions drive substantial differences in resulting valuations.
Among the largest component of resulting value in this model is the value assigned to the horizon (the perpetuity piece beyond the 5- or 10-year mark). Its derivation is a function of assumed growth rate and assumed cost of capital. At estimates of 5 percent and 10 percent, as noted, the multiple is 20; tweak these and enormous ranges emerge.
Even so, the discounted cash flow valuation model is the most widespread model in contemporary valuation.
- Some value investors use it, at least in part.
- Others eschew it entirely.
Also read:
Discounted Cash Flow valuation method
Discounted Cash Flow valuation method
Despite these points about cash flows, the most popular contemporary approach to valuation emphasizes cash flows pure and simple. Called discounted cash flow (DCF) analysis, the method also presents a number of choices an analyst must make.
EBIT and EBITDA: Cash flows can be measured in alternative ways. Chief examples are operating income (earnings before interest and taxes, called EBIT) and operating income plus the noncash expenses of depreciation and amortization (called EBITDA). Devotees of discounted cash flow valuation analysis rarely use accounting-driven metrics such as operating income.
DCF valuation for a medium-term period, typically 5 to 10 years.
Once cash flows are defined using one of these metrics, the discounted cash flow valuation method estimates them for a medium-term period, typically 5 to 10 years.
DCF valuation for period beyond the medium term, to yield the perpetuity amount.
For cash flows beyond the medium term, an additional step estimates the further cash expected in perpetuity, at a constant growing rate. This is typically done by estimating the final year’s cash flows and multiplying it by some figure to yield the perpetuity amount.
The figure is determined by the relationship between the assumed growth rate and the relevant cost of capital at that horizon period.
It is equal to 1 divided by the difference between these rates – so with a cost of capital of 10 percent and a growth rate of 5 percent, the multiplier is 20 determined by 1/ (10 percent – 5 percent).
Overview
The requisite math is elegant, easy, superficially scientific and seemingly objective. The raw data is estimated, just as easily, but substantially artistic and actually subjective. Underscore the heroics:
Despite these points about cash flows, the most popular contemporary approach to valuation emphasizes cash flows pure and simple. Called discounted cash flow (DCF) analysis, the method also presents a number of choices an analyst must make.
EBIT and EBITDA: Cash flows can be measured in alternative ways. Chief examples are operating income (earnings before interest and taxes, called EBIT) and operating income plus the noncash expenses of depreciation and amortization (called EBITDA). Devotees of discounted cash flow valuation analysis rarely use accounting-driven metrics such as operating income.
DCF valuation for a medium-term period, typically 5 to 10 years.
Once cash flows are defined using one of these metrics, the discounted cash flow valuation method estimates them for a medium-term period, typically 5 to 10 years.
The estimate entails examining a range of performance variables that drive cash flows, chiefly sales levels, profit margins, and required reinvestment in the business through capital expenditures (cap-ex).
With cash flows projected, the method discounts each year’s estimate by a discount rate intended to reflect the subject company’s cost of capital during the period.
Each year’s discounted result is added to all others to produce a preliminary valuation of the 5- or 10- year period.
DCF valuation for period beyond the medium term, to yield the perpetuity amount.
For cash flows beyond the medium term, an additional step estimates the further cash expected in perpetuity, at a constant growing rate. This is typically done by estimating the final year’s cash flows and multiplying it by some figure to yield the perpetuity amount.
The figure is determined by the relationship between the assumed growth rate and the relevant cost of capital at that horizon period.
It is equal to 1 divided by the difference between these rates – so with a cost of capital of 10 percent and a growth rate of 5 percent, the multiplier is 20 determined by 1/ (10 percent – 5 percent).
Overview
The requisite math is elegant, easy, superficially scientific and seemingly objective. The raw data is estimated, just as easily, but substantially artistic and actually subjective. Underscore the heroics:
- cash flows estimated for 5 or 10 years,
- cash flows in perpetuity,
- discount rates going out 10 years plus, and
- a growth rate on top of that in perpetuity.
Also read:
Cash Flow Statement Value
Cash flow based valuation techniques (DCF analysis): High Subjectivity
The reason value investing emphasizes the balance sheet and income statement is that to resort solely to the cash flow statement can be deceptively simple.
Cash flows alone disguise important metrics. Cash is not exactly the bottom line. True, cash flows drive value, but some portion of cash flows will be needed to reinvest in capital resources necessary to sustain business production and results.
Thus to arrive at a cash flow figure by adjusting net income for noncash expenditures is only a partial step. Step two is to further adjust that figure by probable future cash commitments to capital expenditures.
Step 1: Adjust earnings for noncash charges
Suppose a company generates net income of $1 million. Part of the expenses recorded to generate the $1 million consisted of net noncash charges of $200,000. Cash flow is thus $1.2 million. That is step one.
Step 2: Free cash flows
Then this figure must be adjusted to reflect the amount the company will need to disburse in cash to maintain its property, plant and equipment at levels sufficient to sustain business productivity. Suppose this figure is either $0.1 million or $0.3 million. Adjusted, cash flows are now either $0.9 million or $1.1 million. This is the bottom line figure, and may be called free cash flows. (Buffett calls it owner earnings to designate that these are the free flows of results allocable to the common stock.)
Too often analysts fail to take this additional step of adjusting for the probable costs of required reinvestment. It would be more accurate for these analysts simply to stick with the net income figure. After all, the noncash charges to earnings that produce the net income figures are at least, in part, intended as a proxy to estimate such required reinvestment.
In this example, the bookkeeping allocation of noncash charges of $0.2 million may be as reasonable an estimate of required cash reinvestment as the separate estimates of either $0.1 million or $0.3 million. But zeroing in on this figure is a crucial value investing exercise.
The reason value investing emphasizes the balance sheet and income statement is that to resort solely to the cash flow statement can be deceptively simple.
Cash flows alone disguise important metrics. Cash is not exactly the bottom line. True, cash flows drive value, but some portion of cash flows will be needed to reinvest in capital resources necessary to sustain business production and results.
Thus to arrive at a cash flow figure by adjusting net income for noncash expenditures is only a partial step. Step two is to further adjust that figure by probable future cash commitments to capital expenditures.
Step 1: Adjust earnings for noncash charges
Suppose a company generates net income of $1 million. Part of the expenses recorded to generate the $1 million consisted of net noncash charges of $200,000. Cash flow is thus $1.2 million. That is step one.
Step 2: Free cash flows
Then this figure must be adjusted to reflect the amount the company will need to disburse in cash to maintain its property, plant and equipment at levels sufficient to sustain business productivity. Suppose this figure is either $0.1 million or $0.3 million. Adjusted, cash flows are now either $0.9 million or $1.1 million. This is the bottom line figure, and may be called free cash flows. (Buffett calls it owner earnings to designate that these are the free flows of results allocable to the common stock.)
Too often analysts fail to take this additional step of adjusting for the probable costs of required reinvestment. It would be more accurate for these analysts simply to stick with the net income figure. After all, the noncash charges to earnings that produce the net income figures are at least, in part, intended as a proxy to estimate such required reinvestment.
In this example, the bookkeeping allocation of noncash charges of $0.2 million may be as reasonable an estimate of required cash reinvestment as the separate estimates of either $0.1 million or $0.3 million. But zeroing in on this figure is a crucial value investing exercise.
Also read:
GROWTH'S VALUE (illustrations)
Take an example drawn from Bruce Greenwald’s detailed book on value investing.
Suppose that earnings are $32. An analyst determines it would cost $20 to grow earnings by 10 percent forever. So you can have either:
· $32 forever with no growth, or,
· $12 ($32 - $20) growing at 10 percent forever.
Which is better, no growth or growth?
It depends on the cost of capital.
Use the following standard valuation formula:
V = D1 / (k-g)
This formula is a variation on the V = D/k when discussing current earnings, giving effect to same rate of growth designated by g.
Illustrations:
k=cost of capital=20%, 16% or 14%
g=growth=0% or 10%
Scenario 1: $32 forever with no growth
k=20%, 16% or 14% and g=0%
V=32/(0.20 – 0)= $160
V=32/(0.16 – 0)=$200
V=32/(0.14 – 0)= $229
Scenario 2: $12 ($32 - $20) growing at 10 percent forever.
k=20%, 16% or 14% and g=10%
V=12/(0.20 – 0.10)= $120
V=12/(0.16 – 0.10)=$200
V=12/(0.14 – 0.10)= $300
Note:
When capital costs equal capital returns, growth neither adds nor subtracts value, no matter how much or how little growth there is. The reason is intuitive: If an investor putting in new capital charges the same rate that capital generates, then there is no additional return available to prior investors.
To come full circle, growth is not free.
The only businesses in the first category are those possessing franchise characteristics. The only way to capture returns on capital greater than the cost of capital is to keep competitors out. If competitors can get in, capital costs and returns will soon converge upon each other (or worse, capital costs will exceed capital returns).
Before turning to examining cash-flow based valuation techniques, note two crucial points:
(1) Assets drive earnings and cash flows, and
(2) Assets are analytically more important than either.
As to point (1):
Suppose that earnings are $32. An analyst determines it would cost $20 to grow earnings by 10 percent forever. So you can have either:
· $32 forever with no growth, or,
· $12 ($32 - $20) growing at 10 percent forever.
Which is better, no growth or growth?
It depends on the cost of capital.
Use the following standard valuation formula:
V = D1 / (k-g)
This formula is a variation on the V = D/k when discussing current earnings, giving effect to same rate of growth designated by g.
Illustrations:
k=cost of capital=20%, 16% or 14%
g=growth=0% or 10%
Scenario 1: $32 forever with no growth
k=20%, 16% or 14% and g=0%
V=32/(0.20 – 0)= $160
V=32/(0.16 – 0)=$200
V=32/(0.14 – 0)= $229
Scenario 2: $12 ($32 - $20) growing at 10 percent forever.
k=20%, 16% or 14% and g=10%
V=12/(0.20 – 0.10)= $120
V=12/(0.16 – 0.10)=$200
V=12/(0.14 – 0.10)= $300
Note:
- The higher the cost of capital, the lower is the return on capital (valuation) and vice versa.
- With a 20-percent cost of capital, $32 forever with no growth ($160) is better than $12 growing at 10 percent forever ($120). Thus, growth subtracts value when the cost of capital exceeds the return on capital.
- With a 16-percent cost of capital, $32 forever with no growth ($200) is the same as that of $12 growing at 10 percent forever ($200). Growth is neutral to value when the cost of capital equals the return on capital.
- With a 14-percent cost of capital, $12 growing at 10 percent forever ($300) is better than $32 forever with no growth ($229). Thus, growth adds value when the return on capital exceeds the cost of capital.
When capital costs equal capital returns, growth neither adds nor subtracts value, no matter how much or how little growth there is. The reason is intuitive: If an investor putting in new capital charges the same rate that capital generates, then there is no additional return available to prior investors.
To come full circle, growth is not free.
- If a company can attract capital at a cost lower than returns it generates, growth adds value.
- If it attracts capital at a cost higher than what it generates, growth subtracts value.
- If the cost of capital is the same as the return on capital, growth is neutral to value.
The only businesses in the first category are those possessing franchise characteristics. The only way to capture returns on capital greater than the cost of capital is to keep competitors out. If competitors can get in, capital costs and returns will soon converge upon each other (or worse, capital costs will exceed capital returns).
Before turning to examining cash-flow based valuation techniques, note two crucial points:
(1) Assets drive earnings and cash flows, and
(2) Assets are analytically more important than either.
As to point (1):
- for most businesses, asset value exceeds earnings value;
- businesses whose earnings value exceeds asset value possess franchise characteristics. This implies the ability to sustain high returns on equity (high earnings relatives to net assets).
- data reliability varies.
- Balance sheet data tend to be most reliable for valuation exercises, then income statement data concerning current earnings.
- Properly estimated cash flows are probably less than earnings, though many contemporary analysts draw the opposite conclusion by ignoring important noncash charges to income such as depreciation.
Also read:
Monday 12 January 2009
GROWTH'S VALUE
GROWTH’S VALUE
Growth is not free.
Its price is the cost of capital necessary to support it.
Growth adds value only when the return on capital exceeds the cost of capital.
When capital costs equal capital returns, growth neither adds nor subtracts value, no matter how much or how little growth there is. The reason is intuitive: If an investor putting in new capital charges the same rate that capital generates, then there is no additional return available to prior investors.
Therefore:
The only businesses in the first category are those possessing franchise characteristics. The only way to capture returns on capital greater than the cost of capital is to keep competitors out.
If competitors can get in, capital costs and returns will soon converge upon each other (or worse, capital costs will exceed capital returns).
To come full circle, growth is not free.
Also read:
Growth is not free.
Its price is the cost of capital necessary to support it.
Growth adds value only when the return on capital exceeds the cost of capital.
When capital costs equal capital returns, growth neither adds nor subtracts value, no matter how much or how little growth there is. The reason is intuitive: If an investor putting in new capital charges the same rate that capital generates, then there is no additional return available to prior investors.
Therefore:
- If a company can attract capital at a cost lower than returns it generates, growth adds value.
- If it attracts capital at a cost higher than what it generates, growth subtracts value.
- If the cost of capital is the same as the return on capital, growth is neutral to value.
The only businesses in the first category are those possessing franchise characteristics. The only way to capture returns on capital greater than the cost of capital is to keep competitors out.
If competitors can get in, capital costs and returns will soon converge upon each other (or worse, capital costs will exceed capital returns).
To come full circle, growth is not free.
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Franchise Value
FRANCHISE VALUE
Franchise businesses are those boasting
· barriers to entry and
· other competitive advantages
that make it too costly for new entrants to join.
1. Strong brands can help, so long as competitors cannot match them.
Examples include at least for some period of time those products bearing names synonymous with the goods, such as Coke, Kleenex, Hoover (in its days), Harley-Davidson (to some extent), and others.
2. Techniques producing franchise value include
· patents,
· exclusive licenses,
· know-how, and
· secret formulae.
· Generally high fixed-costs of entry also help.
3. Common elements of franchise businesses include
· high costs to consumers of switching away from the target’s own product in favor of products sold by competitors,
· high costs to consumers of seeking out such alternatives, and
· habits commanding consumer loyalty.
4. Foes of the franchise power are constraints competitors can evade. Examples are
· a unionized labor force,
· burden-some distribution arrangements, or
· limitations on an entity’s adaptability in the face of change.
Also read:
Franchise businesses are those boasting
· barriers to entry and
· other competitive advantages
that make it too costly for new entrants to join.
1. Strong brands can help, so long as competitors cannot match them.
Examples include at least for some period of time those products bearing names synonymous with the goods, such as Coke, Kleenex, Hoover (in its days), Harley-Davidson (to some extent), and others.
2. Techniques producing franchise value include
· patents,
· exclusive licenses,
· know-how, and
· secret formulae.
· Generally high fixed-costs of entry also help.
3. Common elements of franchise businesses include
· high costs to consumers of switching away from the target’s own product in favor of products sold by competitors,
· high costs to consumers of seeking out such alternatives, and
· habits commanding consumer loyalty.
4. Foes of the franchise power are constraints competitors can evade. Examples are
· a unionized labor force,
· burden-some distribution arrangements, or
· limitations on an entity’s adaptability in the face of change.
Also read:
Estimating Growth in Value Investing
Estimating Growth in Value Investing
Avoid using valuation based on growth estimates
Another reason for pure value investing’s aversion to valuation based on growth estimates is that growth’s potential value can be ascertained using other accounting tools not requiring estimates.
This involves comparing valuation estimates using earnings with those using assets.
Three possibilities arise: The valuations are the same or one or the other is higher.
1. Earnings value = Asset value
When they are the same, growth bears no value as just noted.
2. Asset value > Earnings value
When asset value exceeds earnings value, managers are deploying assets sub-optimally, either due to ineptitude or excess industry capacity. No value resides there.
3. Earnings value > Asset value
When earnings value exceeds asset value, it is due to competitive advantages or barriers to entry, and these clues indicate potential value in growth. This indicates a company possessing franchise value. One measure of that value is the excess of earnings value over asset value. It is captured in the expression return on equity. This economic goodwill makes companies value investor candidates.
Also read:
Avoid using valuation based on growth estimates
Another reason for pure value investing’s aversion to valuation based on growth estimates is that growth’s potential value can be ascertained using other accounting tools not requiring estimates.
This involves comparing valuation estimates using earnings with those using assets.
Three possibilities arise: The valuations are the same or one or the other is higher.
1. Earnings value = Asset value
When they are the same, growth bears no value as just noted.
2. Asset value > Earnings value
When asset value exceeds earnings value, managers are deploying assets sub-optimally, either due to ineptitude or excess industry capacity. No value resides there.
3. Earnings value > Asset value
When earnings value exceeds asset value, it is due to competitive advantages or barriers to entry, and these clues indicate potential value in growth. This indicates a company possessing franchise value. One measure of that value is the excess of earnings value over asset value. It is captured in the expression return on equity. This economic goodwill makes companies value investor candidates.
Also read:
Avoid Extrapolated Future Earnings Growth figures
Avoid assumptions about extrapolated growth in future earnings
Assumptions about growth in future earnings extrapolated from current or past earnings are unreliable for a valuation exercise.
Also suspect for pure value investors are assumptions about growth in future earnings extrapolated from current or past earnings.
Unlike extreme devotees of growth investing, value investors consider current earnings – adjusted as described – to be the best estimate of sustainable future cash flows.
A key reason to deny estimated and unknown earnings growth is that absent sustainable competitive advantages or barriers to competitor entry, growth lacks value.
If new entrants can join a company’s industry as equal competitors, the effect drives a company’s returns to just equal their costs – no upside is sustainable so growth adds nothing.
Growing a business measured in sales requires growing the business measured in assets. Growing assets requires capital, which also poses a cost. Facing competitive entrants, the process goes nowhere (except remotely due to luck and temporarily – benefits value investors do not pay for).
Also read:
Assumptions about growth in future earnings extrapolated from current or past earnings are unreliable for a valuation exercise.
Also suspect for pure value investors are assumptions about growth in future earnings extrapolated from current or past earnings.
Unlike extreme devotees of growth investing, value investors consider current earnings – adjusted as described – to be the best estimate of sustainable future cash flows.
A key reason to deny estimated and unknown earnings growth is that absent sustainable competitive advantages or barriers to competitor entry, growth lacks value.
If new entrants can join a company’s industry as equal competitors, the effect drives a company’s returns to just equal their costs – no upside is sustainable so growth adds nothing.
Growing a business measured in sales requires growing the business measured in assets. Growing assets requires capital, which also poses a cost. Facing competitive entrants, the process goes nowhere (except remotely due to luck and temporarily – benefits value investors do not pay for).
Also read:
Avoid Pro Forma financial figures
Avoid Pro forma financial figures
Pro forma financial figures are unreliable for a valuation exercise
Value investing eschews pro forma financial figures.
These are pictures of performance based on making various assumptions other than those applied in preparing actual financial statements.
While useful for certain exercises such as depicting how a newly merged company would have looked if the merger had occurred some years earlier, they do not represent useful valuation resources in other contexts.
Pro forma figures are the least reliable data in financial reporting and are invariably unreliable for a valuation exercise.
Also read:
Pro forma financial figures are unreliable for a valuation exercise
Value investing eschews pro forma financial figures.
These are pictures of performance based on making various assumptions other than those applied in preparing actual financial statements.
While useful for certain exercises such as depicting how a newly merged company would have looked if the merger had occurred some years earlier, they do not represent useful valuation resources in other contexts.
Pro forma figures are the least reliable data in financial reporting and are invariably unreliable for a valuation exercise.
Also read:
Adjustments in Current Earnings figure
Adjusting current earnings figure
Valuation based on current earnings is equal to current earnings divided by the company’s current cost of capital.
V = E/k
E = Earnings.
k = The cost of capital.
Apart from estimating the cost of equity capital, earnings-based valuation relies on some accounting judgments to confirm the integrity of current earnings.
The exercise may call for adjustments in the reported figures to render the current earnings figure the best estimate of the company’s sustainable long-term cash flows.
Distortion caused by one-time charges
Among justifications for adjusting current earnings is the distortion caused by one-time charges. Companies sometimes bury bad news affecting multiple years into a single charge and dismiss the result as a nonrecurring episode. Adjusting for this practice requires reallocating the one-time charge across multiple periods and adjusting the current year’s earnings accordingly.
Distortion caused by noncash charges
Other justifications for adjusting current earnings are accounting allocations for noncash charges such as depreciation and amortization. These are intended to serve as a proxy for how close a company’s capital assets are drawing to the ends of their useful lives and must be replaced. It is common for the required reinvestment in such capital assets to exceed the amount allocated in the accounting.
Distortion caused by aberrant current year earnings
Current earnings may also be adjusted to the extent that the current year is an aberration for substantive economic reasons. If the year is a cyclical down year for the company, an upward adjustment based on earnings of prior years is indicated; if at a boom in the corporate or industrial business cycle, the reverse would be true.
Also read:
Valuation based on current earnings is equal to current earnings divided by the company’s current cost of capital.
V = E/k
E = Earnings.
k = The cost of capital.
Apart from estimating the cost of equity capital, earnings-based valuation relies on some accounting judgments to confirm the integrity of current earnings.
The exercise may call for adjustments in the reported figures to render the current earnings figure the best estimate of the company’s sustainable long-term cash flows.
Distortion caused by one-time charges
Among justifications for adjusting current earnings is the distortion caused by one-time charges. Companies sometimes bury bad news affecting multiple years into a single charge and dismiss the result as a nonrecurring episode. Adjusting for this practice requires reallocating the one-time charge across multiple periods and adjusting the current year’s earnings accordingly.
Distortion caused by noncash charges
Other justifications for adjusting current earnings are accounting allocations for noncash charges such as depreciation and amortization. These are intended to serve as a proxy for how close a company’s capital assets are drawing to the ends of their useful lives and must be replaced. It is common for the required reinvestment in such capital assets to exceed the amount allocated in the accounting.
Distortion caused by aberrant current year earnings
Current earnings may also be adjusted to the extent that the current year is an aberration for substantive economic reasons. If the year is a cyclical down year for the company, an upward adjustment based on earnings of prior years is indicated; if at a boom in the corporate or industrial business cycle, the reverse would be true.
Also read:
Income Statement Value: The Earnings Payoff
Income Statement Value: The Earnings Payoff
Successful asset leveraging shows up in the income statement.
The income statement reports revenues less expenses and depicts an important measure of business performance. This is not a picture of cash flows because GAAP uses accrual, not a cash method of reporting.
In accrual accounting, economic activity is recorded according to the relationship between revenue and expense, rather than the timing of cash inflows or outflows. This is not an idiosyncrasy of accounting tradition, but a reflection of accounting’s goal of measuring and allocating business events that reflect economic reality. Those accruals capturing noncash costs of doing business reflect that cash will be absorbed in the future.
Pure value investors (Graham and Dodd) believe that current earnings (adjusted) are the most reliable indicator of a company’s sustainable long-term cash flows.
Adding a further constraint, pure value investors believe that the most reliable way to use current earnings as a valuation metric is to assume they will be constant in the future at current rates – not grow according to estimates.
The math is easy.
Valuation based on current earnings is equal to current earnings divided by the company’s current cost of capital.
That is,
V = E/k.
E = Earnings are earnings.
k = The cost of capital. (This is the company’s weighted average cost of debt and cost of equity. The former can be calculated simply; the latter still requires some estimating).
Successful asset leveraging shows up in the income statement.
The income statement reports revenues less expenses and depicts an important measure of business performance. This is not a picture of cash flows because GAAP uses accrual, not a cash method of reporting.
In accrual accounting, economic activity is recorded according to the relationship between revenue and expense, rather than the timing of cash inflows or outflows. This is not an idiosyncrasy of accounting tradition, but a reflection of accounting’s goal of measuring and allocating business events that reflect economic reality. Those accruals capturing noncash costs of doing business reflect that cash will be absorbed in the future.
Pure value investors (Graham and Dodd) believe that current earnings (adjusted) are the most reliable indicator of a company’s sustainable long-term cash flows.
Adding a further constraint, pure value investors believe that the most reliable way to use current earnings as a valuation metric is to assume they will be constant in the future at current rates – not grow according to estimates.
The math is easy.
Valuation based on current earnings is equal to current earnings divided by the company’s current cost of capital.
That is,
V = E/k.
E = Earnings are earnings.
k = The cost of capital. (This is the company’s weighted average cost of debt and cost of equity. The former can be calculated simply; the latter still requires some estimating).
The virtues of this approach are simplicity and reliability:
- Characteristic of simplicity is that investors need not bother with growth rates because no growth is assumed.
- Both data points are known or can be reliably estimated.
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