BMW's Operating Leverage

A recent Wall Street Journal article highlights the operating leverage for several auto manufacturers. For example, BMW lost €666 million ($784.1 million) during the most recent quarter. A large part of the loss was due to the company's operating leverage. BMW loses $.43 for every dollar of lost sales, which of course means that the company gains $.43 for every increased dollar of sales. By way of comparison, Fiat Chrysler's operating leverage is about 18%, GM's is about 20%, and Ford's is about 25%. As a result, we would expect BMW's earnings to be more volatile when compared to other auto companies.

Smart Money Versus Dumb Money

The growth of passive investing, that is, investing in index funds, has arisen in large part due to the growing popularity of the efficient market hypothesis. In short, it seems that outperforming the stock market is a difficult, if not impossible, task. As a result, retail investors, sometimes referred to as dumb money, have flocked to index funds. A common belief on Wall Street is that in a severe market downturn, retail investors would flee the market. The 30 percent drop in the market over the past month has been a severe downturn. But, when fund flows, which is the amount of money put into or pulled out of an investment, is examined, the two S&P 500 Index ETFs favored by individuals showed net buying, while the ETF preferred by professionals showed net selling. In other words, the professionals ran and mom and pop actually bought more. With the market up about 5 percent for today, maybe dumb money does know a little more than previously believed.

Lower Taxes, NPV, and Company Value

A major benefit of the Tax Cuts and Jobs Act of 2017 is that it reduces taxes paid, which increases operating cash flow. Increased cash flow can increase the NPV of a project, even turning a negative NPV to a positive NPV, and increase the overall value of a company. Since the value of a project or the value of a company are both based on the present value of future cash flows, this result is fairly obvious. As a recent article points out, what is less obvious is that the reduced tax rate will also increase the required return on a project or a company. Since the cost of debt that is important for either valuation is the aftertax cost of debt, a reduced tax rate actually makes the cost of capital higher, all else the same. So, in discounting higher future cash flows with a higher cost of capital, the present value will not increase as much as you might think at first glance.

Corporate Underinvestment

A recent article indicates that financial managers may not be following good capital budgeting techniques. The median hurdle rate used to value new projects is 12.0 percent, with an average rate of 13.6 percent. Meanwhile, the same survey notes that the median WACC is 9.8 percent, with a mean of 10.6 percent. While that article infers that these numbers should be the same, we differ on this assumption. If new projects are riskier than the company, which would likely be the case, then the cost of capital for new projects would necessarily be greater than the WACC since the required return on a project depends on the use of funds, not the source of funds.

Underinvestment still does occur, as 67 percent of respondents answers “No” when asked if their company undertook all projects that create value. Common reasons given for not pursuing value creating projects were:

Shortage of management time and expertise (51%)

The project is not consistent with the company’s core strategy (41%)

The risk of the project is too high (39%)

Shortage of funds (38%)

Shortage of employees (32%)

The (Partial) Effects Of Tax Reform

With the U.S. corporate tax rate being among the highest among developed economies, there is discussion of corporate tax reform that would reduce the corporate tax rate from 35 percent to 20 percent, as well as the possibility of eliminating the deduction of interest expense entirely. So how would this affect corporate finance? A cut in the corporate tax rate on interest would reduce the attractiveness of debt as a form of financing, thereby reducing the amount of debt in the optimal corporate capital structure. One estimate is that the U.S. average debt-to-EBITDA ratio would drop from 4.1 to about 3 times, which would also affect the other financial leverage ratios. And the non-deductibility of interest expense would affect the calculation of the weighted average cost of capital. And, finally, at least for now, the decline in corporate debt will likely increase the credit rating for the remaining debt, driving the yield down on debt that does remain. All in all, major changes to U.S. based corporations.

What Is Dell Really Worth?

While students often expect that stock price valuation should result in an exact price that everyone agrees with, this almost never happens in practice. Take the court case involving Dell's management buyout (MBO). When the MBO went through in 2103, the price calculated by management experts, through a year-long process, was $13.78 per share. However, a group of dissident shareholders had independent experts value Dell at $28.61 per share, a difference of $28 billion. In the valuation, both parties used the same components: the forecast cash flows for a specific period, the value of the cash flows beyond that period, and the discount rate (WACC). However, the experts differed on the company's capital structure, as well as the cost on equity. In the end, the court used its own assumptions and arrived at a share price of $17.62 per share. As you can see from Dell, experts can use the same technique and arrive at widely differing answers when valuing a company.

Private Company Valuation

With a public company, the price per share is easy to obtain by looking at the stock market. For private companies, stock prices are more difficult. Although you can price a private company using multiples or free cash flow techniques, the valuation of private companies by mutual funds shows how much disagreement exists. For example, cloud-based storage company Dropbox is valued at $9.40 per share by T. Rowe Price, while Hartford Financial Services Group has a value of $15.20 per share. The valuations on database software company are even wider, ranging from $8.06 to $18.55. As Jeff Grabow, head of the valuation practice at EY states, “Valuation is as much an art as it is a science.”

WACC And Acquisitions

An article on CFO discusses the WACC for S&P 500 companies and the use of the WACC in mergers and acquisition. An interesting number in the article is that, according to research by Bain & Company, the average WACC for a company in the S&P 500 has dropped from 10 percent in 2010 to 8 percent in 2014. Much of this is likely due to lower interest rates. The article also discusses how companies add a risk premium of 200 to 300 basis points to the WACC (the subjective approach) when analyzing a potential acquisition, plus another 50 to 100 basis points due to conservatism about the WACC calculation. Although the article is not specific, we should reiterate the correct WACC to use when analyzing a potential acquisition is the WACC of the target company, not the WACC of the acquiring company. To clarify terminology, the hurdle rate used in the article is the required return, or cost of capital.  

An Uber Valuation

So is Uber ($40 billion) really worth more than insurers Aetna ($38 billion), Prudential ($38 billion), or grocer Kroger ($37 billion)? Probably not, but venture capital valuations can be quite tricky. A recent article discusses some of the fuzziness associated with valuing a private company. In fact, some venture capitalists argue that the valuation of private companies is just a placeholder. Snapchat, the photo-messaging app, has a $15 billion valuation, yet the company has almost no revenues to speak of. One reason for the extraordinarily high valuation of private companies is that VCs often have deals that protect them going forward.

Mutual Fund Efficiency

In a nod to market efficiency, 2014 was one of the worst years on record for mutual fund managers, with fewer than 20 percent beating their benchmark. In the article, several reasons are given for the poor performance. For example, relative, not absolute skill is what matters. In other words, if fund managers as a whole are getting smarter, it is harder for an individual fund manager to distinguish themselves from the pack. Additional explanations, such as the necessity of small caps doing better than large caps, cash not being a drag on the fund return, and good performance of international stocks, are given as possible explanations for the poor performance in 2014. While we see merit in these explanations, a simpler reason also emerges. In very few years do mutual fund managers as a whole outperform the market. This leads us to the argument that the market is efficient and the reasons given in the article are only reasons that mutual fund managers performed even more poorly than usual.

Ratio Valuation Of The Clippers

Steve Ballmer's $2 billion bid for the Los Angeles Clippers shocked many people. Leaked court documents show why. Ballmer's bid was 12.1 times revenues (Price/sales ratio). For the last 25 NBA teams that were sold, only four have sold at a ratio above 4.0, and none had a ratio above 5.0. Similarly, the $2 billion bid price implies an EBITDA multiple of 12.1 times, while the league average has been 6.0 to 6.4 times EBITDA. All in all, it appears that Ballmer is willing to pay a high price for the Clippers, at least relative to revenue and EBITDA. 

Exxon's Performance

While we don't often discuss an analyst's report, a recent report on Exxon caught our eye. One way to create a positive NPV project is to have economic moats. An economic moat can be a competitive advantage over others in the same industry, or barriers to entry. The article discusses several concepts that we think should interest you after what you have learned in this class so you can see how key concepts are applied in other areas of finance. For example, the article discusses Exxon's low cost of capital (Why would Exxon have a lower cost of capital than its competitors?), as well as economic rents. You can think of economic rents as a positive NPV. The article also discusses Exxon's lower F&D (finding and development) costs in relation to its peers, as well as a lower cost structure, which is the application of ratio analysis.

Capital Budgeting And WACC In Practice

The Association of Financial Professionals recently released its 2013 AFP Estimating and Applying Cost of Capital Survey. The report is rather lengthy, but we would like to discuss some of the findings.

Eighty-five percent of the companies surveyed used discounted cash flow analysis for capital budgeting projects. For those of you who are worried about projecting cash flows far into the future, 51 percent of the companies used an explicit 5-year cash flow projection and 26 percent used an explicit 10-year cash flow projection. After that estimation period, a terminal valuation is used to account for cash flows beyond that period. Additionally, 72 percent of companies used scenario analysis when evaluating a new project.

When estimating the cost of equity, 85 percent of companies use the CAPM. The choice of the risk-free rate is varied, with 39 percent using the 10-year Treasury, which is not consistent with our choice. There is also a disparity in practice whether to apply the current, historical, or forward risk-free rate. The choice of beta is also widely varied, with companies choosing different sources, estimation periods, return frequency, adjustment of the estimated beta toward one, and delevering and relevering beta.

As we discussed in the textbook, many argue that the market risk premium since 1926 is unsustainable going forward. The survey results show the variation in the market risk premium used. Seventeen percent of companies use a market risk premium of 3 percent or less, while 19 percent use a market risk premium of 6 percent or more. One thing we should mention about the market risk premium relates back to the choice of the Treasury used to proxy the risk-free rate. The choice of a longer term Treasury over a shorter term Treasury would result in a lower market risk premium, assuming an upward sloping yield curve. Because the choice of which Treasury maturity should proxy the risk-free rate is directly related to the market risk premium, interpreting the results of this question in isolation is problematic.  

Finally, for those students who feel that they are struggling with finance, rest assured that you are not alone. We would fail the 36 percent of the companies in this survey who use the current book value debt/equity ratio. As we mentioned numerous times, book values are not useful in most instances, but rather market values should be used. However, the 17 percent of companies that use the current book debt/current market equity ratio for the capital structure weights would pass our classes since the book value and market value of debt are generally close.

Economic Profit

McKinsey Quarterly recently published an article on the results of its study of economic profit for 3,000 large companies. If you prefer, a narrated slideshow discussing the results is also available. As a quick review, economic profit is also known as Economic Value Added (EVA) and is similar to an NPV calculation for the company as a whole. The results of the study show the disparities between the top and bottom performers from middle-of-the-pack companies. Surprisingly, bottom performers tend to have higher revenues than middling performers, have the highest tangible-capital ratio, but the lowest asset turnover. They are likely to be in a capital intensive industry such as airlines, electric utilities, and railroads. Top performers tend to have high margins and a low tangible-capital ratio.

Interestingly, top performers were likely to remain as such, in part due to more fresh capital. In other words, they stay on top because they get bigger and seem to invest in profitable projects. Of course, a company can improve its performance, but much of the improvement lies in the industry. In fact, companies that do improve (or experience a decline) in economic profit tend to be driven by industry performance. The results of the study indicate that as much as 54 percent of a company's economic profit is due to its industry. Interestingly though, top quintile companies rely the least on industry effects.

What Is A Name Worth?

For many companies, the brand name may be one of the most important assets. According to Interbrand, a leader in the valuation of brand names, the Apple brand is worth about $98 billion and Google's brand is worth about $93 billion. If you look at the methodology, you will see the financial analysis Interbrand uses for the valuation. The valuation method is economic profit, or economic value added (EVA), which was popularized by Stern-Stewart. Economic profit is the aftertax operating profit of the company minus a charge for the capital used. When discounting the projected aftertax operating profit, Interbrand references the industry WACC. You should note that the brand valuation is not just the name, but closer to the company value. Would you really buy the Apple name for $98 billion without the ability to sell iPhones, iPads, and iTunes? Probably not. One last question: Does the economic profit concept look familiar to you? We would hope so since it is basically an NPV analysis of the company as a whole, not just the NPV of an individual project.

A Tangled Web Of Values: Enterprise Value, Firm Value, And Market Cap

Our guest blogger this week is Dr. Aswath Damodaran from the Stern School at NYU. Dr. Damodaran is a noted expert on valuation and publishes his own blog, Musings on Markets. Dr. Damodaran has published numerous articles, including his updated article on the equity risk premium. Here, he discusses the different methods of valuing a company, a shortened version of his more detailed post.

Investors, analysts, and financial journalists use different measures of value to make their investment cases, and it is not a surprise that these different value measures sometimes lead to confusion. For instance, at the peak of Apple's glory early last year, there were several articles making the point that Apple had become the most valuable company in history, using the market capitalization of the company to back the assertion. A few days ago, in a reflection of Apple's fall from grace, an article in WSJ noted that Google had exceeded Apple's value, using enterprise value as the measure of value. What are these different measures of value for the same firm? Why do they differ and what do they measure? Which one is the best measure of value?

So what are the different measures of value? The first measure is the market value of equity, which measures the difference between the market value of all assets and the market value of debt. The second measure of market value is firm value, the sum of the market value of equity and the market value of debt. The third measure of market value nets out the market value of cash & other non-operating assets from firm value to arrive at enterprise value. One of the features of enterprise value is that it is relatively immune (though not completely so) from purely financial transactions.

Each of these measures has problems. For example, to find the market values of equity, you need updated "market" values for equity, debt and cash/non-operating assets. In practice, the only number that you can get on an updated (and current) basis for most companies is the market price of the traded shares. You also must adjust for non-traded shares, management options, and convertible securities. To get from that price to composite market values often requires assumptions and approximations, which sometimes are merited but can sometimes lead to systematic errors in value estimates. When valuing debt, you must value non-traded debt and off balance sheet debt. Even cash presents problems when dealing with operating versus non-operating cash and cash trapped offshore. 

When it comes to which value estimate is the best, I am an agnostic, and I think each one carries information to investors. The PE ratio may be old fashioned, but it still is a useful measure of value for individual investors in companies, and enterprise value has its appeal in other contexts. Understanding what each value measure is capturing and being consistent in how it is computed, compared and scaled is far more important than finding the one best measure of value.

Copper Mine NPV

Tintina Resources announced that its Preliminary Economic Assessment (capital budgeting analysis) of the company's Black Butte Copper Project in central Montana resulted in an IRR of 30.5 percent, an NPV of $218 million at a cost of capital of 8 percent, and a 3.6 year payback. The company announced a post-tax NPV of $110 million, but infortunately appears to have used the same 8 percent cost of capital. A pre-tax valuation should use a pre-tax interest rate, while a post-tax valuation should use a post-tax interest rate. 

A Bad Cost Of Capital

Yahoo's recent acquisition of Tumblr has been viewed by many as an acqui-hire of Tumblr's founder David Karp. However, for some analysts, the acquisition is a $1.1 billion mistake. And while we haven't done an analysis of the acquisition ourselves, we really hate it when others make glaring mistakes in their analysis. In the article, the author states:

"The WACC of 9.8% feels high. If we instead use the risk-free rate of 4.5%, then the U.S.-only RPM hurdle rate drops to $0.81, the international-included RPM hurdle rate drops to $0.41."

We have several really big problems with this statement. A WACC of 9.8 percent seems fairly reasonable for a blog hosting company that derives its revenue from advertising. We estimated GE's WACC at www.thatswacc.com and were given a WACC of 7.12 percent. Given that Tumblr is riskier than GE, we would argue that if anything, 9.8 percent could even be a little low. If that weren't bad enough, the author decides to use the risk-free rate in place of WACC, which is the same as saying that the acquisition of Tumblr is risk-free! Finally, the author uses a 4.5 percent risk-free rate. Given that the 30-year Treasury bond currently yields about 3.3 percent, we would love to get a 4.5 percent risk-free rate.

Sustainable Capital Budgeting

Sierra Nevada, maker of the famed Pale Ale, has utilized sustainable practices since the company's inception, largely as a measure to reduce costs. As the company has grown, it has retained the practice but has taken a more stringent examination of new projects. But, Bill Bales, the company's CFO, has noted that vendors often present unrealistic results. With energy-savings projects, vendors typically use future energy costs that are out of line with today's relatively low costs. Additionally, vendors account for tax credits that are unavailable to the company. Perhaps most egregiously, vendors will alter the capitalization rate (WACC) to make a project's NPV positive. As Bales notes, "What was wrong with the capitalization rate to begin with?"

Stock Picking

One question we often get is "What should I invest in?" Although we feel that we have a pretty good feel for investments, we would like to point you to a recent article written by economist N. Gregory Mankiw. While we are loathe to take investment advice from an economist (although some of our best friends are economists), Professor Mankiw makes some important points about investing, namely: 1) The market processes information quickly. The market is efficient. 2) Price moves are often inexplicable. In other words, we don't always understand what caused a stock price change, even after the fact. 3) Holding stocks is a good bet. The equity risk premium more than makes up for the riskiness of stocks over the long-term. 4) Diversification is essential. If you don't believe this, reread Chapter 11. 5)  Smart investors think globally. Why? Global investment increases diversification.