Wednesday, June 10, 2015

Billion-dollar Tech Babies: A Blessing of Unicorns or a Parcel of Hogs?

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.

Breaking the Unicorn barrier
If the conventional definition of a unicorn is a private business with a valuation that exceeds a billion, how do you arrive at the valuation of such a business? While you have no share prices or market capitalizations for these companies, you can extrapolate to the values of private businesses, when they raise fresh capital from venture capitalists or private investors. Thus, if a venture capitalist invests $100 million in a company and gets 10% of the ownership in the company in return, we estimate a value of $1 billion for that company, making it a Unicorn. There are, however, two problems that get in the way of a good estimation. One is that the capital infusion changes the value of the company, creating a distinction between pre-money and post-money values. The other is that the investor's equity investment generally comes with bells and whistles, designed to protect the investor from downside risk and these protections can skew the value estimate.

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.

2. Investor Optionality
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).

No free lunches
As an outsider with an interest in valuation, I find venture capital deals to be jaw-droppingly complex and not always intuitive, and I am not sure whether this is by design, or by accident. When it comes to investor protection, the stories that I read for the most part are framed as warnings to owners about "vulture capital" investors who will use these protection clauses to strip founders of their ownership rights. I think the story is a far more complex one, where both investors and owners see benefits in these arrangements, and where both can expose themselves to dangers, if they over reach.

Private Company Investors
It is easy to see why private company investors like protections against downside risk, especially when investing in young start-ups, where valuation is difficult to do. However, there are three consideration that investors need to keep in mind, when deciding how much protection to seek.
  1. At a fair price, protection adds no value: In investing, you can, for the most part, buy protection agains the downside (in the form of insurance or put options), if you are willing to pay the right price. At a fair price, the protection delivers peace of mind but no additional value. In the example above, the prices that I computed for downside protection were fair prices and neither the investor nor the owner lose at that price. Thus, an investor can either invest $100 million, with no downside protection, and ask for 13.35% of the post-money value of $748.84 million, or get full downside protection and settle for 10.00% of the artificially inflated post-money value of $1 billion.
  2. Paper Protection:  When investing in young start-ups with uncertain futures, the protection clauses in agreements often deliver far less than they promise. The anti-dilution provisions fail if the business you invest in never seeks out additional capital and the liquidation preferences that many investors add to their investments will not provide much respite when these young businesses are forced to liquidated, since their valuations tend to be heavily tilted towards human and idea capital. It should therefore come as no surprise that a significant portion of venture capital investments, promise and protection notwithstanding, yield little or nothing for investors. At the risk of offending some of my readers, I would argue that the protection clauses in most venture capital investments have more in common with the rhythm approach for birth control, a hit-or-miss system that delivers big surprises, than with full-fledged contraception.
  3. Abdication of valuation responsibilities: Venture capitalists who view building in protection against the downside as an alternative to making valuation judgments are seeking false security. As an investor, if I were asked to choose between investing with a venture capitalist who makes good valuation judgments but is not adept at building in downside protection or with a venture capitalist who is superb at building in downside protection but haphazard about valuation judgments, I would pick the venture capitalist who makes good valuation judgments every single time. 
There is also the very real concern is that some venture capitalists who believe that they are protected from downside risk (even if that belief is misplaced) may be inclined to take reckless risks in investing.
There are three benefits to founders and entrepreneurs from granting protection to investors. The first is that they allow them to raise capital in circumstances where its might not otherwise have been feasible. The second is that granting these protections may give the founders/owners more freedom to run the businesses as they see fit, without constant investor oversight. The third is that it allows for inflated valuations, as illustrated in the example above, that can then yield either bragging rights or access to more capital.

The costs are equally clear. If owners give away too much of the firm for bragging rights, they will be worse off. In the example above, for instance, where we estimated the value of protection to be approximately $25.12 million, giving the investors more than 10% of the unadjusted post-money value of the business in return for $100 million in capital invested would be giving up too much. This cost is exacerbated by a behavioral quirk, which is that the founder owners of a business often tend to be far more confident about its future success than the facts merit. The same over confidence and faith that makes them successful entrepreneurs also will lead you to under price the investor protections that they are giving away in return for capital.

Public Market Investors
While public market investors may view these arrangements between venture capital investors and founder owners as an inside-VC game, they can be sucked into the game in one of two ways. The first is when public market investors are drawn to invest in private businesses, drawn by the allure of high returns (and not wanting to be left out). The second is when private businesses go public and investors are trying to estimate a fair price to pay for the offered shares.

In both cases, it is natural to look at the post-money valuations that emerge from prior capital rounds and use those values as anchors in determining fair prices to pay. After all, not only are these real transactions (rather than abstract valuations), but the assumption is that the venture capitalists who were able to invest in these rounds must be smarter and better-informed than the rest of us. I think that both assumptions are shaky, the first because the structuring of the transaction (with investor protection and capital infusion) affecting the observed post-money valuations and the second because any investor group (no matter how savvy it might be) is capable of becoming irrationally exuberant. Investors can take the first steps in protecting themselves by doing their homework. A private company that is planning on going public has to reveal the details of protective clauses and other carry overs from prior capital rounds in its prospectus.

Some unsolicited suggestions
There is nothing wrong with investors seeking protection from downside risk, just as there it is perfectly natural for owners to seek to pump up post-money valuations to make themselves more attractive to new capital providers. The damage occurs when one or both groups let these desires dominate its investing and business decisions. At the risk of sounding presumptuous, I would suggest the following:

  1. Be real: Both sides would be well served by reality checks. Investors have to be recognize that the protection they are getting is porous and contingent on capital raising events and owners have to realize that offering these protections may alter how and when they raise additional capital, perhaps to the detriment of their businesses.
  2. Keep it simple: The only people who gain from complexity are lawyers, accountants and consultants. I may be missing the historical context here, but I think that there are far simpler ways of building in protection than the standards that exist today.  For instance, rather than continuing with the practice of adjusting price per share for dilution, which is the practice today, I think it would be far simpler to write the protection in terms of dollar capital invested.
  3. Check the price of protection: At the right price, protection creates value for neither investors nor founder owners. If the protection is priced too high, with the investor settling for a far smaller percentage of the unadjusted value than he or she should, it is not worth it. If the protection is priced too low, founder owners are giving up too much of their businesses in return for the capital raised.
  4. Don't forget your fundamentals: While the presence or absence of protection may make a difference in marginal investments, it should not fundamental change the businesses you invest in, if you are investor, or how you run your business, if you are an owner. Thus, if investors  use the presence of downside protection as a reason for investing in over valued businesses, they will lose out in the end. (And making that investment convertible and calling it preferred will not make it a good investment.)  By the same token, founders who give away much larger percentages of their businesses than they should, to pump up post-money valuations, will regret that decision in good times, and even more so in bad times. 

  1. Valuing Investor Protection

Wednesday, June 3, 2015

Cash, Debt and PE Ratios: Cash is an upper and debt is a downer!

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.


Wednesday, May 27, 2015

The Value and Pricing of Cash: Why low interest rates & large cash balances skew PE ratios

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
I start my valuation class with a simple exercise. I hold up an envelope with a $20 bill in it (which everyone in the class has seen me put into the envelope) and ask people how much they would pay for the envelope.  While some find this exercise to be absurd, it does bring home a very simple rule, which is that valuing cash should not require complicated valuation models or the use of multiples. Unfortunately, I see this rule broken on a daily basis as investors mishandle cash in companies, both in intrinsic valuation and pricing models.

To illustrate the divide between risky assets and cash, assume that you are trying to value a software company, with a cash balance (which is invested in liquid, riskless or close-to-riskless investments) of $200 million. Let's assume that the accounting income statement & balance sheet for the company looks as follows:

If you believe the accounting balance sheet, this company is half software and half cash but that is misleading for two reasons. The first is that assets on accounting balance sheets are not marked to market and can remain at low values, even as their earnings power rises. The second is that accounting rules (absurdly) treat R&D, the biggest capital expenditure at technology firms, as operating expenses, which then results in those assets never showing up on the balance sheet. The ripple effects of understating the book value of equity can be seen in the high returns on equity that I report for the firm.

Having established that book-value cash ratios will be skewed by the changing composition of the market, let's turn to the question of valuing this company. For simplicity, let's assume that the cost of equity for investing in the software business is 10% and that the expected growth in income from software is 2% in perpetuity. If we assume that the company can maintain its existing return on equity of 36% on its new investments in perpetuity, the value of the software business is:

  • Expected net income from software = $72 million
  • Expected reinvestment to generate growth = 2%/36% = 5.56%
  • Value of Software business = 72 (1-.0556)/ (.10-.02) = $850 million
The cash is invested in liquid, riskless investments earning 2% (pre-tax). The fact that cash earns a low rate of return does not make it a bad investment, because that low rate of return is what you should expect to make on a short-term, riskfree investment. If you decide to do an intrinsic valuation of the income from cash, you should discount the income at the risk free rate:
  • Expected pre-tax income from cash = $ 200 (.02) = $4 million
  • Cost of equity = Riskfree rate = 2%
  • Value of equity = 4/.02 = $200 million
The intrinsic value balance sheet for this company is shown below:
Note that the software business is now worth a lot more than it was in the accounting balance sheet but that cash value remains unchanged. The value of equity on the balance sheet is an intrinsic equity value.

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
In the market, we observe the PE ratios for equity in companies, and those PE ratios will be affected by both how much cash the company holds and the interest rate it earns on that cash.  To the extent that cash balances (as a percent of value) vary across time, across sectors and across companies, the conclusions we draw from looking at PE ratios can be skewed by these variations. To observe how much of an impact the cash holdings have on the observed PE ratio for a company, I varied the cash balance in my software company from 0% to 50% of the intrinsic value of the company; at 50%, the cash balance is $850 million and is equal to the value of the software business. The PE ratio for equity in the company is shown in the graph below, with the cash effect on PE highlighted:

The effect of holding cash is accentuated when the interest rate earned on cash, which should be a short term risk free (or close to risk free) rate, is low relative to the cost of equity. In the table below, I highlight the interest rate effect, by holding the cost of equity fixed at 8% and varying the risk free rate from 1% to 5%:
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%.

It is true that companies with global operations are accumulating some of their cash overseas to avoid US taxes. Bringing in trapped cash into this process is easy to do and requires you to separate cash balances into domestic and trapped cash; the biggest problem that you face is getting that information, since most companies are not explicit about the division. While the domestic cash balance is its stated value, the trapped cash will see its value reduced by the expected tax liability that will be incurred when the cash is repatriated (which will require assumptions about when that will be and what the differential tax rate paid on repatriation will amount to.)

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
With short-term risk free rates hovering around zero and cash balances close to historical highs, you would expect the cash effect on PE to be more pronounced now than in the past. To measure this effect, I computed PE ratios and non-cash PE ratios each year for US companies, using the following equations:

The interest income from cash was estimated using the average cash balance during the course of the year and average one-year T.Bill rate for that year. In the graph below, I look at the paths of both measures of PE from 1962 through 2014. Note that while while both series move in the same direction, the divergence has become larger since 2008; in 2014, the non-cash PE was almost 30% lower than the conventional PE.

Update: The PE effect is large, especially in the last five years. It is perhaps being exaggerated by the inclusion of financial service firms in the sample, since cash and short term investments at these firms can be huge and are really not comparable to cash holdings at other companies. If you remove them from the sample, the cash effect does get smaller. Rather than pick and choose which data I will report, I have included the year-by-year averages for the US for four sets of data: all companies, only non-financial service companies, all money-making companies and all non-financial money-making companies in this link

I know that the talk of a bubble gets louder each day, and while there may be legitimate reasons to worry about the level of stock prices, those who base their bubble arguments entirely on PE ratios (normalized, adjusted, current) may need to revisit their numbers. All of the versions of the PE will be "pushed up" by the cash holdings of US companies and the low interest rate environment that we live in.

Sector Differences in Cash and PE
Cash balances have varied not only across time but they are also different across sectors and within sectors, across companies. Consequently, comparing PE across sectors or even across companies within a sector, without adjusting for cash, can be dangerous, biasing you away from companies with large cash balances (which will look expensive on an unadjusted PE) and especially so during periods of low interest rates.

In the first part of the analysis, I estimated cash as a percent of firm value, PE ratios and non-cash PE for each sector in 2014. (I eliminated financial service companies from my sample, since I am not sure that I can categorize cash as a non-operating asset for these companies). While all of the industry averages can be downloaded at the link below, the sectors where the cash effect on PE was greatest are listed below:

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
In an investing world full of complications, simple measures like PE retain their hold because they are easy to compute and easy to work with. However, there is a price that we sometimes pay for this simplicity, and in periods like this one, where interest rates are at historic lows, we may need to reassess how we use these measures to compare companies. In particular, I think we have to separate companies into their cash and operating parts, and deal with the two separately, because they are so different in terms of risk and earnings power. Thus, it we are using multiples, enterprise value multiples will work better than equity multiples, and with equity multiples, non-cash versions (where the cash is stripped from market capitalization and net income is cleansed of the cash effect) will be more reliable than cash versions. This will also mean that the time honored way of estimating PE, i.e., dividing the market price today by the earnings per share, will have to be replaced by an approach where we use use aggregated market value, cash and earnings, rather than per share numbers. 


  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)


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

Monday, May 25, 2015

No Light at the end of the Tunnel: Investing in Bad Businesses

I am a cynic when it comes to both CEOs and equity research analysts. I think that many CEOs are political animals, bereft of vision and masters at using strategic double-speak to say absolutely nothing. I also believe that many equity research analysts are creatures of mood and momentum, more market followers than leaders. Once in while, though, my cynicism is upended by a thoughtful CEO or a well-done equity research report and even more infrequently by both happening at the same time, as was the case in this recent interplay between Sergio Marchionne, Fiat Chrysler's CEO, and Max Warburton, the auto analyst at Sanford Bernstein.

The CEO/Analyst Exchange on Fiat Chrysler
Sergio Marchionne is an unusual chief executive, a man who is not afraid to talk the language of investors and is open about the problems confronting not only his company, but also the entire automobile business. While he has been arguing that case for a while, sometimes in public and sometimes with other auto company executives, he crystallized it in a presentation he made in an analyst conference call, titled "Confessions of a Capital Junkie". In the presentation, he argues that the auto business has not generated its return on capital over its last cycle and that without significant structural changes, it will continue to under perform. He then diagnoses the reason for the under performance as over investment in R&D and capital costs, with companies duplicating each other's efforts. He concludes with the remedy of consolidation, where with mergers and joint ventures, companies could co-operate and reduce their capital costs, and asks analysts and investors in auto companies to apply pressure for change. Mr. Marchionne's pitch was unusual was two reasons.  First, how many CEOs admit that their businesses have gone bad and that fundamental change is needed in how they are run? Second, it is unusual for a CEO to ask investors to become more activist and push for change, since most CEOs prefer a pliant and forgiving shareholder base.

Max Warburton, Bernstein's auto analyst who was at the conference, responded by asking "“Do you think the German [car manufacturers] have any interest in what we say?', arguing that investors and analysts were powerless to push for change. In an extended analyst report, Mr. Warburton went further, making the point that shareholders are way down the list of priorities for the typical auto company, and especially so in Europe and Asia. 

As I said at the start, this is the type of exchange between CEOs and analysts that you hope to see more of, and I agree with both Mr. Marchionne and Mr. Warburton on some aspects and disagree on others. I agree with both men that the auto business has been in trouble for a while and I made this point earlier in my post on GM buybacks. However, I don't think that the problem is one of duplication of expenses and that the answer is the consolidation of companies, as argued by Mr. Marchionne, and here is why. For consolidation to generate higher profits at auto companies, they will have to ensure that they don't  pass the cost savings on to customers by cutting car prices, and nothing in the behavior of the auto industry in the last decade leads me to believe that they are capable of this concerted action. I agree with Mr. Warburton that the auto business is not shareholder-focused and that institutional forces (governments, unions) will make it difficult for investors to be heard. While there are investors in the market who will continue to supply capital at favorable terms to this business, sensible investors are under no obligation to play this game. Abandoning the auto business is not feasible if you are the auto analyst at Sanford Bernstein, but it is a viable option for the rest of us, at least until prices reflect the quality of these businesses. This debate also raises interesting fundamental questions that I hope to examine in the rest of the post, including how we categorize businesses into good and bad ones, why businesses become bad, why companies continue to operate and sometime expand in bad businesses and why investors may still seek to put their money in these companies.

What is a bad business?
If Mr. Marchionne's point is that the automobile business is a bad one, it is worth starting this discussion with the question of what it is that make a business a bad one. At an extremely simplistic level, you can argue that a bad business is one where many or most companies lose money, but that definition would encompass young sectors (social media, biotechnology) that tend to lose money early in the life cycle. It also would imply that any sector that collectively makes profits is a good one, which would not make sense, if the sector has huge amounts of capital invested in it. Thus, any good definition of business quality has to look at not only how much money a company makes but how much it needs to make, given its risk and the capital invested in that business. In corporate finance, we try, to capture this by looking at both sides of the equation:

While there are some business (banks, investment banks and other financial service companies), where the equity comparison is more useful, in most businesses, it is the comparison on a overall capital basis that carries more weight. If you accept the proposition that the return on invested capital measures the quality of a company’s investment and the cost of capital is the hurdle rate that you need to earn, given its risk, the spread between the two becomes a snapshot of the capacity of the company to generate value.

Why a snapshot? If the return on invested capital is estimated, as it usually is, using the operating income that the company generated in the most recent time period and the cost of capital reflects the expected return, given the risk free rate and equity risk premium in that period, it is also possible that looking at a single period can give you a misleading sense of whether the company in question is generating value. With cyclical and commodity companies, in particular, where earnings tend to move through cycles, a good case can be made that we should be looking at earnings over a cycle and not just the most recent year. Finally, the return on invested capital is an accounting number and is hence handicapped by all the limitations of accounting principles & rules, a point I made in this long, torturous examination of accounting returnsIf you bring the two strands of discussion together, there are two levels at which a sector has to fail to be called a “bad” business.
  1. Collective, weighted under performance: Most companies in the sector should be earning returns on their invested capital that are less than the cost of capital, not just a few, and the aggregate return on capital earned by a sector has to lag the cost of capital.
  2. Consistent under performance: These excess returns (return on capital minus cost of capital) should be negative over many time periods.
  3. No delayed payoff: There are some infrastructure businesses that require extended periods of large investment and negative excess returns, before they pay off in profitability.
In my post on GM, I made the case that the automobile business was a bad one, using these two metrics. Collectively, the distribution of returns on capital across global automobile companies in 2014 looked as follows:

If you look at the return on capital across time for the auto industry, you see the same phenomenon play out.

It should come as no surprise that I agree with Mr. Marchionne that the auto business is a bad one and with Mr. Warburton that the companies in this business are in denial. The bad news for investors is that the auto business is not alone in this hall of shame. I computed returns on capital, costs of capital and excess returns for all non-financial US companies, by year from 2005 to 2014, and then looked for the sectors that delivered a negative excess return on average during the decade, while also generating in excess returns in at least 5 of the 10 years:
Raw data from Capital IQ with my estimates of costs of capital by year
Some of the businesses on this list have a good reason for being on the list and perhaps can be cut some slack. For instance, the green and renewable energy business has delivered negative excess returns both in the aggregate and in every year for the last decade, but in its defense, it may be a business that needs time to mature. The real estate sector is well represented on this list, with REITs, homebuilding, building materials and real estate operations & development all making the list with negative excess returns. An optimist may argue that the last decade created the perfect storm for real estate, unlikely to be repeated in the near future, and that these businesses will return to adding value in the future. There are some surprises, with entertainment software, wireless telecom and broadcasting all making the list, suggesting that you can have bad businesses that are growing. Finally, there were 169 companies that were classified as diversified, and their excess returns were negative every year for the entire decade, making a strong argument that many of these companies would be better off broken up into constituent parts. It is true that the returns on capital in this table were computed using standard accounting measures of operating income and debt, and I recomputed them, with leases capitalized as debt to derive the following table:
Operating Income and Invested Capital, adjusted for leases treated as debt
The list looks almost identical to the unadjusted excess return rankings, though the excess returns for restaurants, retailers and other larger lessees became much smaller with the adjustment and airlines make the worst business list, once you consider leases as debt.

How do businesses go bad?
So, why do businesses go bad? There are a number of reasons that can be pointed to, some rooted in sector aging, some in competition, some in business disruption and some in delusions about growth and profitability.
  1. The Life Cycle: I have used the corporate life cycle repeatedly in my posts as an anchor in trying to explains shifts in capital structure, dividend policy and valuation challenges. It is a useful device for explaining why some sectors fail to deliver returns that meet their costs of capital. In particular, as sectors age, their returns seem to drift down and if the sector goes into decline, with revenues stagnant or falling, companies are hard pressed to generate their costs of capital. At the other end of the life cycle, young sectors that require large infrastructure investments often deliver extended periods of negative excess returns.
  2. Competitive Changes: A business can be changed fundamentally if the competitive landscape changes. This can happen in many ways. A legal barrier to competition (patents, exclusive licenses) can be removed, opening up existing companies to price competition and lower margins. Globalization has played a role as well, as companies that used to generate excess returns with little effort in protected domestic markets find themselves at a disadvantage, relative to foreign competitors. 
  3. Disruption: Disruption is the catchword in strategy and in Silicon Valley, and while it is often hyped and over used, technology has disrupted established businesses. Uber and its counterparts are laying to waste the taxi business in many cities and Amazon has changed the retail business beyond recognition, driving many of its brick and mortar competitors out of business.
  4. Macro Delusion: While all of the above can be used to explain why an old business can become a bad one, there are new businesses that sometimes never make it off the ground, even though they are launched in markets with significant growth potential. One reason is what I have termed the macro delusion, where the sum of the dreams and forecasts of individual companies
Why do companies stay in bad businesses?
If you are a company that finds itself in a  bad business, there are four options to consider. The first is to exit the business, extracting as much of your capital you can to invest in other businesses or return to the suppliers of capital. While this may seem like the most logical choice (at least from a capital allocation standpoint), there is a catch. It is unlikely that you will be able to get your original capital back on exit, because buyers will have reassessed the value of your assets, based on their diminished earnings power. Consider, for instance, a company that generates a 3% return on capital on invested capital of $1 billion and assume that its cost of capital is 6%. If a sale of the assets or business will deliver less than $500 million, the best option for the company is to continue to operate in the bad business. The second is to retrench or shrink the business, by not reinvesting back into the business and returning cash from operations back to stockholders (as dividends or buybacks). That was the rationale that I used in supporting the GM buyback. The third is to continue to run the business the way you used to when the business was a good one, hoping (and praying) that things turn around. That seems to be the response of most in the auto business and explains the cold shoulder that they gave to Mr. Marchionne's prescription (of consolidation). The last is to aggressively attack a bad business, with the intent of changing its characteristics, to make it a good one. This is a strategy, with the potential for high returns if you do succeed, but with low odds of success. Not surprisingly, it is the strategy that appeals the most to CEOs who want to burnish their reputations and it one reason that I posited that my returns on my Yahoo! investment would be inversely proportional to Marissa Mayer's ambitions.

Of the four strategies, the one that is least defensible is to the third one (doing nothing), but that seems to be most common strategy adopted by companies in bad businesses and I can think of four reasons why it continues to dominate. The first is inertia, where managers are unwilling or unable to change their learned behavior, with the resistance become greater, if they have long tenure in the business. The second is poor corporate governance, where those who run firms view shareholders as just another stakeholder group and view costs of capital as abstractions rather than as opportunity costs. The third are institutional factors which can conspire to preserve the status quo, because there are benefits derived by others (labor unions, governments) from that status quo.  The final factor is behavioral, where the easiest path for managers, when faced with fundamental changes in their businesses, is to do nothing and hope that the problem resolves itself. 

Why do investors invest in these companies?
If it is difficult to explain why companies choose to stay and sometimes grow in bad businesses, it is far easier to explain why investors may invest in these companies. At the right price, any company, no matter how bad its business, is a good investment, just as at the wrong price, any company, no matter how good its business, is a bad investment. To decide whether to invest in a company in a bad business, investors have to value these companies and there are challenges. The first is that with these companies, growth is almost always more likely to destroy value than to increase it. Consequently, the value of these companies is maximized as they minimize reinvestment, shrink their businesses and liquidate themselves over time. The second problem is that while designing a valuation model that allows for a shrinking company is easy enough to do, the value that you get is operational only if management in the company does not undercut you, by aggressively seeking out growth with expensive reinvestment. I present responses to these problems in this paper.

As a passive investor, you have to accept your powerlessness over management and build, into your expectations, what you believe that the management will do in terms of investment, financing and dividend policy, no matter how irrational or value destroying those actions may be. As an activist investor, though, you may be able to force managers to reassess the way they run the company. It should come as no surprise that the classic targets of activist investors tend to be companies in bad business that are run by managers in denial. Finally, while the debate about corporate governance has atrophied into one about director independence, corporate governance scores and CEO pay, the real costs of poor corporate governance are felt most intensely in companies that operate in bad businesses, where without the threat of shareholder activism, managers often behave in irrational, value-destructive ways.

Closing Thoughts
As I look at the excess returns generated by companies in different sectors, I am struck by how little margin for error there seem to in many businesses, with excess returns hovering around zero. If we attach large values to the disruptors of existing businesses, consistency requires us to reassess the values of the disrupted companies. Thus, if we are bidding up the values of Tesla,  Uber and Google (driverless cars) because they might disrupt the automotive business, does it not stand to reason that we should be bidding down (at least collectively) the values of Volkswagen, Ford and Toyota? More generally, we seem to be more willing to anoint the winners from disruption than we are in identifying and repricing the losers.

  1. Industry averages excess returns, by year: 2005-2014
  2. Industry average costs of capital: US
  3. Industry average cost of capital: Global