Wednesday, January 16, 2019

THE LIONEL MESSI OF FINANCE

"Stories without numbers are just fairy tales" — Aswath Damodaran

Agustin Mackinlay | @agumack

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

In my finance courses in Barcelona I call Aswath Damodaran “the Lionel Messi of Finance”. In a recent CNBC interview, the New York University professor was introduced as “the Dean of valuation”. And in a recent podcast with blogger Barry Ritholz, he called himself “the Kim Kardashian of valuation”. Whatever the nickname, one thing is certain: prof. Damodaran is a super-star in the world of finance—particularly in valuation. Although Narrative and Numbers was published in 2017, the recent fall in risky assets has rekindled interest on the book. In particular, the valuation of Amazon presented in chapter 9 has led prof. Damodaran to take a short position in that stock—a tremendously successful trade that has been widely discussed in academic circles and in the financial press.

Storytelling: a double-edged sword 
With Narrative and Numbers, prof. Damodaran joins a growing list of authors who emphasize the importance of storytelling skills in business. The list includes, among others, best-selling authors Peter Guber, John Hagel, Joshua Glenn and Rob Walker. “A well-told story connects with listeners in a way that numbers never can”, writes Damodaran. Good stories help people better understand what you are saying; they get remembered; they are likely to generate a favorable response. And they can lead to action.

We often tell in class the story of how Warren Buffet lent $5 billion to Goldman Sachs in the midst of the catastrophic fallout from the Lehman Brothers bankruptcy. That particular trade wasn’t his biggest money-maker; yet it allows us to illustrate the link between risk and reward in quite a dramatic way—something that numbers alone cannot achieve. Good stories, writes the author of Narrative and Numbers, reach our hearts and minds in a way that plain facts are unlikely to do. But there is a dark side to storytelling in business. A recent convert to behavioral finance and to the works of Nobel Prize-winner Daniel Kahnemann, Prof. Damodaran points to the danger of “letting emotions run away from the facts”. He cites the cases of fraudster Bernard Madoff and of blood-testing firm Theranos as illustrations of the risks created by stories that are simply too good to be true. Fraudsters, as it turns out, are oftentimes excellent storytellers.

Numbers to the rescue 
Chapter 7 of Narrative and Number is perhaps the most useful of the entire book. Equity analysts are provided with rules that enable them to “test-drive” a narrative. A good story must not only be possible: it must be plausible and even probable. One example will suffice. In a simple two-stage growth valuation model, terminal value (TV) —the value at horizon of all subsequent perpetual cash flows— is the most important number, often accounting for more than 70% of the valuation. The formula:

TV = cash flow at horizon + 1 / (rg)

where r is the discount rate and g is the perpetual growth rate of cash flows after horizon, is described by prof. Damodaran as “an equation taught in finance classes around the world and often reproduced with little thought by analysts”. Careless analysts and lecturers regularly throw perpetual growth rates of 10% in a world of near-zero risk-free rates of return (at least in key European currencies). This is plainly absurd: g should be set at or below the nominal risk-free rate, which acts as a proxy to the long term nominal growth rate of GDP—otherwise a company could become larger than the entire economy. I pay a lot of attention to these issues in my valuation courses, and Narrative and Numbers contains a detailed list of cases where numbers can come to the rescue of a narrative gone wild. 

More on cash flows, less on discount rates
In Narrative and Numbers prof. Damodaran puts decidedly more emphasis on projecting cash flows than on calculating discount rates. Gone are the chapter-long discussions of the Capital Asset Pricing Model (CAPM) and bottom-up betas that are the hallmark of his previous books. This is a welcome development. To project the amount of resources that companies need to invest in order to sustain growth, prof. Damodaran relies on the sales-to-capital ratio. Particularly noteworthy are the valuations of Uber, Ferrari and Amazon. These valuations, based on Free Cash Flow to the Firm (FCFF) projections, provide useful class material.

The emphasis on the sales-to-capital ratio is particularly interesting, as financial ratios with sales on the numerator are coming back to the forefront of equity valuation thanks to Financial Times contributor Stuart Kirk. Recently, Mr. Kirk has suggested that new technologies like “machine-learning” are destined to forever change our assumptions about valuation, as depreciation is likely to be replaced by appreciation when the availability of massive amounts of data finally yields more precise algorithms and better performance over time. How would prof. Damodaran’s models cope with these new realities?

Pretty well, I would suggest. A good narrative, far from being self-contained, should be open-ended—and the FCFF valuation model is flexible enough to accommodate the changes suggested by Mr. Kirk. Until these changes materialize, a good old-fashioned valuation will never cease to entertain and instruct. Having shorted the stock of Amazon at nearly $2,000/share and the stock of Apple when the Cupertino giant was worth a trillion dollars in market capitalization, Prof. Damodaran can attest to the power of the traditional, reliable models that I am keen to introduce to our students. 
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Thursday, December 21, 2017

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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Tuesday, September 19, 2017

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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Sunday, September 17, 2017

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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Monday, September 11, 2017

'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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