CALCULATING THE GROWTH RATE IN EARNINGS

AM | @agumack

"The retention ratio and the payout ratio are two sides of the same coin" — Aswath Damodaran 


In Security Analysis (BSF311) I briefly showed on the whitedboard Prof. Damodaran's calculation of the growth rate in earnings per share when applying the Dividend Discount Model (DDM). It was a bit fast, a perhaps a little confusing. So here it goes again (*). First, state the growth rate g where NI stands for Net Income and ROE stands for Return on Capital:

g = (NIt - NIt-1)/Nt-1

Then use the book value of equity to compute ROE (remember that we use book values when assessing past performance, and market values when valuing assets today):

ROEt = NIt / Equityt <=> NIt = ROEt * Equityt-1 [1] and NIt-1 = ROEt-1 * Equityt-2 [2]

Now let us define Equityt-1 as the sum of Equityt-2 and retained earnings in period t-1 (REt-1):

Equityt-1 = Equityt-2 + REt-1 [3]

We can now re-write [1] using [3]:

NIt = ROEt * Equityt-2 + ROEt * REt-1 [4]

If we assume that the return on equity is unchanged, then ROEt = ROEt-1 = ROE. Therefore we can rewrite [4] as:

NIt = ROEt-1 * Equityt-2 + ROEt-1 * REt-1 [5]

Because the first term of [5] is just NIt-1 as defined in [2], the growth rate is:

                                              g = ROE * (REt-1/NIt-1)

Where (REt-1/NIt-1) is the retention rate. Says Prof. Damodaran: "The growth rate in earnings per share of a firm can be written as the product of two variables—the percentage of the net income retained in the firm to generate future growth (retention ratio) and the return earned on equity in these new investments [...] Firms that have higher retention ratios and earn higher returns on equity should have much higher growth rates in earnings per share than firms that do not share these characteristics".

Stay tuned for more on this from Prof. Damodaran.

(*) Aswath Damodaran. Applied Corporate Finance, Fourth Edition (New York: John Wiley & Sons, 2015), p. 523 and Investment Valuation, Third Edition (New York: John Wiley & Sons, 2012), pp. 285-287. 
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GLOBAL DOLLAR LIQUIDITY WEEKLY: VERY BULLISH!

AM | @agumack

With the release U.S. Federal Reserve latest weekly H.4.1 report on monetary aggregates, we are happy to announce very bullish news (in terms of the global economy): the EU Business School Finance Club Global Dollar Liquidity measure is growing at the fastest pace in ... ages! It stands now at $7.8 trillion:

USD million
Custody holdings	$3,370,216	+7.62%
Fed credit	$4,431,256	+0.45%
Global Liquidity	$7,801,472	+3.43%

The stock of custody holdings —US Treasury securities held by 'foreign' central banks— is up by an amazing $188.6bn this year. The implications (at least in my mind) are the following: (a) bullish EM currencies; (b) bearish US dollar; (c) bullish risk assets in general.

Famous last words? Yes, I know.
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THE SALES-TO-CAPITAL RATIO IN VALUATION

AM | @agumack

"A firm can arrive at a high ROC by using its capital to increase sales" — Aswath Damodaran

In his latest book on valuation, Aswath Damodaran pays less attention to the calculation of discount rates, and much more to the projection of cash flows. It's a bit less fun, but more useful. The key tool here is the sales-to-capital ratio; it allows us to compute reinvestment, a key input in FCFF estimations (*):

                             FCFF = EBIT (1 – t) – [Cap Ex – depreciation + ΔWC]

The second term to the right of the equation captures the reinvestment needed for growth: net investment (Cap Ex minus depreciation) plus additional net investments in working capital. The sales-to-capital ratio or capital turnover ratio is:

                             Sales-to-capital = sales / book value of debt and equity

The next step is to compute the change in sales and the change in capital, that is, reinvestment. Now all the pieces come together. If you have an estimation of the sales-to-capital ratio and a revenue (sales) projection, you can arrive at reinvestment by dividing the change in sales by the sales-to-capital ratio. For example, in the World Domination scenario for Amazon (p. 145) sales are projected at $246.9bn in year 6 and at $278.8bn in year 7, while the sales-to-capital ratio is kept constant at 3.68 times. Therefore reinvestment in year 7 is:

                            ($278.8bn – $246.9bn) / 3.68 = $8.6bn

Now all that remains to do to arrive at FCFF is to subtract that number from the projection of the after-tax EBIT, which Prof. Damodaran puts at $17.3bn. Therefore, in year 7, Free Cash Flow to the Firm is $17.3bn – $8.6bn = $8.7bn.

(*) Aswath Damodaran. Narrative and Numbers. The Value of Stories in Business. New York: Columbia Business School, 2017. See also: "Valuing Young, Start-up and Growth Companies: Estimation Issues and Valuation Challenges", Stern School of Business, New York University, 2009, especially pp. 26-27
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A SHORT NOTE ON AMAZON

AM | @agumack

"Your margin is my opportunity" — Jeff Bezos

In Cases in Finance BBA321 we analyze Prof. Damodaran's valuation of Amazon [AMZN] with Free Cash Flow to the Firm [1]. As he does in most valuations in his latest book, he projects reinvestment by means of the sales-to-capital ratio [see]. His line on Amazon can be summarized in a couple of sentences: the internet giant is deliberately chasing revenue in order to become dominant in as many areas as possible; at that point, its market power would eventually enable it to drastically improve margins and profits. It doesn't hurt if, along the way, new business opportunities (with higher margins) pop up. This last point is not emphasized enough in Prof. Damodaran's narrative. The reason for that apparent 'neglect' is obvious: it was written in 2014, before the explosion of Amazon Web Services.

* * *

I was reminded of this as I read Richard Waters' informative piece on Amazon and Microsoft's alliance to link their voice-activated digital assistants [2]. Everybody in the AI space wants to be the platform company par excellence. While this happened with PCs and smartphones, Mr. Waters thinks that in the field of AI "it will be difficult for any single platform company to dominate. That explains the alliance between Amazon and Microsoft. They have more to gain from joining forces against mutual enemies Google and Apple. Their decision to connect highlights a shared weakness: their failure to crack the smartphone market". Note that platform companies command significant premia in PE terms: 18x vs. only 13x for large-cap hardware vendors, according to Morgan Stanley. From an Amazon press release:

SEATTLE--(BUSINESS WIRE)--Aug. 30, 2017-- Amazon (NASDAQ:AMZN) and Microsoft (NASDAQ: MSFT) announced today that Alexa will be able to talk to Cortana, and Cortana will be able to talk to Alexa. You will be able to turn to your Echo device and say, "Alexa, open Cortana," or turn to your Windows 10 device and say, "Cortana, open Alexa."Alexa customers will be able to access Cortana's unique features like booking a meeting or accessing work calendars, reminding you to pick up flowers on your way home, or reading your work email – all using just your voice. Similarly, Cortana customers can ask Alexa to control their smart home devices, shop on Amazon.com, interact with many of the more than 20,000 skills built by third-party developers.

 


[1] Aswath Damodaran. Narrative and Numbers. The Value of Stories in Business. New York: Columbia Business School, 2017.

[2] Richard Waters: "Microsoft and Amazon steal AI march as they look past smartphones", Financial Times, 1 September 2017.
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'CLEANING PROCESS' BY THE CENTRAL BANK OF RUSSIA

Ilya Shashkin | @ishashkin

“Russian Central Bank revokes Yugra's license” – reports Reuters on the regulatory decision from 28th July 2017, which means the 30th largest Russian consumer bank is shut down. Yugra violated banking rules and falsified its accounts (Reuters, July 28, 2017). This is the biggest case in the policy named ‘cleaning’, which started when Elvira Nabiullina took over as governor of Russian Central Bank in 2013. The regulator revokes licenses of the banks, which are considered fraudulent or whose operations raise concerns. The new policy is not revolutionary: during the period 2005-2012, the Central Bank revoked 50 licenses, but these were only small regional banks, and the media did not put too much focus on them.

* * *

Once Nabiullina became the head of the major economic authority, the number of banks shut down increased exponentially, and big players were on the blacklist too (Master-Bank, 2013). Since that moment, people started discussing the trend and named it ‘cleaning’, but those who understood the purpose of it preferred the word ‘healing’. The main target was to reduce the number of weak financial companies or those with too risky credit policy or fraudulent operations. By ‘fraudulent operations’ the regulatory means massive cash outflow to foreign countries or unusual records in the balance sheet. “Our work to clean up the banking sector looks like the work of a financial investigator, rather than a modern banking regulator” (Vasily Pozdyshev - deputy governor at Russia's central bank).



At this point, the interference of the CB in the banking sector did not stop. At the end of August 2017, Russia's 6th largest banking group Otkritie (transl. “Discovery”) was suspected by the regulator. The CB was watching the bank since Fall 2016, when it started to face liquidity problems. The level of capital was obviously inadequately low in comparison to its operations and risk level, and in the official reports – considerably overstated (Dmitry Tulin, the first vice-chairman at CB, Vedomosti). A few days later, the CB decided to buy-out 75% stake in the bank. Why doing so? Otkritie is a giant financial service group that includes four retail banks: Otkritie, Rocketbank, Tochka, Trust; one investment banking; one brokerage division; one open-end fund and 2 insurance divisions. Altogether, they make Otkritie 6th largest financial institution in Russia. If it collapsed, the economy would face the following negative outcomes:

· The bank withdrew 26% of deposits in June and July, totaling 433 billion rubles ($7,4 billion). In the case of collapse, apart from those who manage to quickly withdraw their savings, millions of other deposit holders would be left without money;

· Once their financial status got low, they could not get any credit

· Less credits in the system – the economy is not stimulated and may even stagnate

Drowning a large financial group is not acceptable, which was envisioned by the CB, which decided to save Otkritie. They prevented the Lehman effect in the Russian banking system and created a too-big-to-fail mentality (Dmitri Barinov, Union Investment Privatfond GmbH).
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