Wednesday, August 24, 2016

Superman and Stocks: It's not the Cape (CAPE), it's the Kryptonite (Cash flow)!

Just about a week ago, I was on a 13-hour plane trip from Tokyo to New York. I know that this will sound strange but I like long flights for two reasons. The first is that they give me extended stretches of time when I can work without interruption, no knocks on the door or email or phone calls. I readied my lecture notes for next semester and reviewed and edited a manuscript for one of my books in the first half on the trip. The second is that I can go on movie binges with my remaining time, watching movies that I would have neither the time nor the patience to watch otherwise. On this trip, however, I made the bad decision of watching Batman versus Superman, Dawn of Justice, a movie so bad that the only way that I was able to get through it was by letting my mind wander, a practice that I indulge in frequently and without apologies or guilt. I pondered whether Superman needed his suit or more importantly, his cape, to fly. After all, his powers come from his origins (that he was born in Krypton) and not from his outfit and the cape seems to be more of an aerodynamic drag than an augmentation. These deep thoughts about Superman's cape then led me to thinking about CAPE, the variant on PE ratios that Robert Shiller developed, and how many articles I have read over the last decade that have used this measure as the basis for warning me that stocks are headed for a fall. Finally, I started thinking about Kryptonite, the substance that renders Superman helpless, and what would be analogous to it in the stock market. I did tell you that I have a wandering mind and so, if you don't like Superman or stocks, consider yourself forewarned!

The Stock Market’s CAPE
As stocks hit one high after another, the stock market looks like Superman, soaring to new highs and possessed of super powers.

There are many who warn us that stocks are overheating and that a fall is imminent. Some of this worrying is natural, given the market's rise over the last few years, but there are a few who seem to have surrendered entirely to the notion that stocks are in a bubble and that there is no rational explanation for why investors would invest in them. In a post from a couple of years ago, I titled these people as  bubblers and classified them into doomsday, knee jerk, conspiratorial, righteous and rational bubblers. The last group (rational bubblers) are generally sensible people, who having fallen in love with a market metric, are unable to distance themselves from it.

One of the primary weapons that rational bubblers use to back up their case is the Cyclically Adjusted Price Earnings (CAPE), a measure developed and popularized by Robert Shiller, Nobel prize winner whose soothsaying credentials were amplified by his calls on the dot com and housing bubbles. For those who don’t quite grasp what the CAPE is, it is the conventional PE ratio for stocks, with two adjustments to the earnings. First, instead of using the most recent year’s earnings, it is computed as the average earnings over the prior ten years. Second, to allow for the effects of inflation, the earnings in prior years is adjusted for inflation.  The CAPE case against stocks is a simple one to make and it is best seen by graphing Shiller’s version of it over time.
Shiller CAPE data (from his site)
The current CAPE of 27.27 is well above the historic average of 16.06 and if you buy into the notion of mean reversion, the case makes itself, right? Not quite! As you can see, even within the CAPE story, there are holes, largely depending upon what time period you use for your averaging. Relative to the fully history, the CAPE looks high today, but relative to the last 20 years, the story is much weaker. Contrary to popular view, mean reversion is very much in the eyes of the beholder.

The CAPE’s Weakest Links
Robert Shiller has been a force in finance, forcing us to look at the consequences of investor behavior and chronicling the consequences of “irrational exuberance”. His work with Karl Case in developing a real estate index that is now widely followed has introduced discipline and accountability into real estate investing and his historical data series on stocks, which he so generously shares with us, is invaluable. You can almost see the “but” coming and I will not disappoint you. Of all of his creations, I find CAPE to be not only the least compelling but also potentially the most dangerous, in terms of how often it can lead investors astray. So, at the risk of angering those of you who are CAPE followers, here is my case against putting too much faith in this measure, with much of it representing updates of what my post from two years ago.
1. The CAPE is not that informative
The notion that CAPE is a significant improvement on conventional PE is based on the two adjustments that it makes, first by replacing earnings in the most recent period with average earnings over ten years and the second by adjusting past earnings for inflation to make them comparable to current earnings. Both adjustments make intuitive sense but at least in the context of the overall market, I am not sure that either adjustment makes much of a difference. In the graph below, I show the trailing PE, normalized PE (using the average earnings over the last ten years) and CAPE for the S&P 500 from 1969 to 2016 (last twelve months). I also show Shiller's CAPE, which is based on a broader group of US stocks in the same graph.
Download spreadsheet with PE ratios
First, it is true that especially after boom periods (where earnings peak) or economic crises (where trailing earnings collapse), the CAPEs (both mine and Shiller's) yield different numbers than PE.  Second, and more important, the four measures move together most of the time, with the correlation matrix shown in the figure. Note that the correlation is close to one between the normalized PE and the CAPE, suggesting that the inflation adjustment does little or nothing in markets like the US and even the normalization makes only a marginal difference with a correlation of 0.86 between the unadjusted PE and the Shiller PE.

2. The CAPE is not that predictive
The question then becomes whether using the CAPE as a valuation metric yields judgments about stocks that are superior to those based upon just PE or normalized PE. To test this proposition, I looked at the correlation between the value sof different metrics, including trailing PE, CAPE, the inverse of the dividend yield, earnings yield and the ratio of Shiller PE to the Bond PE) today and stock returns in the following year and the following five years:
There is both good news and bad news for those who use the Shiller CAPE as their stock valuation metric. The good news is that the fundamental proposition that stocks are more likely to go down in future periods, if the Shiller CAPE is high today, seems to be backed up. The bad news is two fold. First, the relationship is noisy or in investment parlance, the predictive power is low, especially with one-year returns. Second, the trailing PE actually does a better job of predicting one-year returns than the CAPE and while CAPE becomes the better predictor than trailing PE over a five-year period, it is barely better than using a dividend yield indicator.  While I have not included these in the table, I will wager that any multiple (such as EV to EBITDA) would do as good (or as bad, depending on your perspective) a job as market timing.

As a follow-up, I ran a simple test of the payoff to market timing, using the Shiller CAPE and actual stock returns from 1927 to 2016. At the start of every year, I first computed the median value of the Shiller CAPE over the previous fifty years and assumed an over priced threshold at 25% above the median (which you can change). If the actual CAPE was higher than the threshold, I assumed that you put all your money in treasury bills for the following year and that if the CAPE was lower than the threshold, that you invested all your money in equities. (You can alter these values as well). I computed how much $100 invested in the market in 1927 would have been worth in August of 2016, with and without the market timing based on the CAPE:

Download spreadsheet and change parameters
Note that as you trust CAPE more and more (using lower thresholds and adjusting your equity allocation more), you do more and more damage to the end-value of your portfolio. The bottom line is that it is tough to get a payoff from market timing, even when the pricing metric that you are using comes with impeccable credentials. 

3. Investing is relative, not absolute
Notwithstanding its weak spots, let’s take the CAPE as your measure of stock market valuation. Is a CAPE of 27.27 too high, especially when the historic norm is closer to 16? The answer to you may sound obvious, but before you do answer, you have to consider where you would put your money instead. If you choose not to buy stocks, your immediate option is to put your money in bonds and the base rate that drives the bond market is the yield on a riskless (or close to riskless) investment. Using the US treasury bond as a proxy for this riskless rate in the United States, I construct a bond PE ratio using that rate:
Bond PE = 1/ Treasury Bond Rate
Thus, if you invest in a treasury bond on August 22, with a yield of 1.54%, you are effectively making 64.94 (1/.0154) times your earnings. In the graph below, I graph Shiller’s measures of the CAPE against this T.Bond PE from 1960 to 2016:
Download T Bond Rate PE data
I also compute a ratio of stock PE to T.Bond PE that will use as a measure of relative stock market pricing, with a low value indicating that stocks are cheap (relative to T.Bonds) and a high value suggesting the opposite. As you can see, bringing in the low treasury bond rates of the last decade into the analysis dramatically shifts the story line from stocks being over valued to stocks being under valued. The ratio is as 0.42 right now, well below the historical average over any of the time periods listed, and nowhere near the 1.91 that you saw in 2000, just before the dot com bust or  even the 1.04 just before the 2008 crisis. 

4. Its cash flow, not earnings that drives stocks
The old adage that it is cash flows, not earnings, that drives stocks is clearly being ignored when you look at any variant of PE ratios. To provide a sense of what stock prices look like, relative to cash flows, I computed a multiple of total cash returned to stockholders by companies (including buybacks) and compared these multiples to Shiller’s CAPE in the graph below:
S&P 500 Earnings and Cash Payout
Here again, there seems to be a disconnect. While the CAPE has risen for the market, from 20.52 in 2009 to 27.27 in 2016, as stocks soared during that period, the Price to CF ratio has remained stable over that period (at about 20), reflecting the rise in cash returned by US companies, primarily in buybacks over the period.

Am I making the case that stocks are under valued? If I did, I would be just as guilty as those who use CAPE to make the opposite case. I am not a market timer, by nature, and any single pricing metric, no matter how well reasoned it may be, is too weak to capture the complexity of the market. Absolutism in market timing is a sign of either hubris or ignorance.


The Market’s Kryptonite
At this point, if you think that I am sanguine about stocks, you would be wrong, since the essence of investing in equities is that worry goes with it. If it’s not the high CAPE that is worrying me, what is? Here are my biggest concerns, the kryptonite that could drain the market of its strength and vitality.
  1. The Treasury Alternative (or how much are you afraid of your central bank?)  If the reason that you are in stocks is because the payoff for being in bonds is low, that equation could change if the bond payoff improves. If you are Fed-watcher, convinced that central banks are all-powerful arbiters of interest rates, your nightmares almost always will be related to a meeting of the Federal Open Market Committee (FOMC), and in those nightmares, the Fed will raise rates from 1.50% to 4% on a whim, destroying your entire basis for investing in stocks. As I have noted in these earlier posts, where I have characterized the Fed as the Wizard of Oz and argued that low rates are more a reflection of low inflation and anemic growth than the result of quantitative easing, I believe that any substantial rate rises will have to come from shifts in fundamentals, either an increase in inflation or a surge in real growth. Both of these fundamentals will play out in earnings as well, pushing up earnings growth and making the stock market effect ambiguous. In fact, I can see a scenario where strong economic growth pushes T. bond rates up to 3% or higher and stock markets actually increase as rates go up.
  2. The Earnings Hangover It is true that we saw a long stint of earnings improvement after the 2008 crisis and that the stronger dollar and a weaker global economy are starting to crimp earnings levels and growth. Earnings on the S&P 500 dropped in 2015 by 11.08% and are on a pathway to decline again this year and if the rate of decline accelerates, this could put stocks at risk. That said, you could make the case that the earnings decline has been surprisingly muted, given multiple crises, and that there is no reason to fear a fall off the cliff. No matter what your views, though, this will be more likely to be a slow-motion correction, offering chances for investors to get off the stock market ride, if they so desire.
  3. Cash flow Sustainability: My biggest concern, which I voiced at the start of the year, and continue to worry about is the sustainability of cash flows. Put bluntly, US companies cannot keep returning cash at the rate at which they are today and the table below provides the reason why:

YearEarningsDividendsDividends + BuybacksDividend PayoutCash Payout
200138.8515.7430.0840.52%77.43%
200246.0416.0829.8334.93%64.78%
200354.6917.8831.5832.69%57.74%
200467.6819.40740.6028.67%59.99%
200576.4522.3861.1729.27%80.01%
200687.7225.0573.1628.56%83.40%
200782.5427.7395.3633.60%115.53%
200849.5128.0567.5256.66%136.37%
200956.8622.3137.4339.24%65.82%
201083.7723.1255.5327.60%66.28%
201196.4426.0271.2826.98%73.91%
201296.8230.4475.9031.44%78.39%
2013107.336.2888.1333.81%82.13%
2014113.0139.44101.9834.90%90.24%
2015100.4843.16106.1042.95%105.59%
2016 (LTM)98.6143.88110.6244.50%112.18%
In 2015, companies in the S&P 500 collectively returned 105.59% of their earnings as cash flows. While this would not be surprising in a recession year, where earnings are depressed, it is strikingly high in a good earnings year. Through the first two quarters of 2016, companies have continued the torrid pace of buybacks, with the percent of cash returned rising to 112.18%. The debate about whether these buybacks make sense or not will have to be reserved for another post, but what is not debatable is this. Unless earnings show a dramatic growth (and there is no reason to believe that they will), companies will start revving down (or be forced to) their buyback engines and that will put the market under pressure. (For those of you who track my implied equity risk premium estimates, it was this concern about cash flow sustainability that led me to add the option of allowing cash flow payouts to adjust to sustainable levels in the long term).

So, how do these worries play out in my portfolio? They don’t explicitly but they do implicitly affect my investment choices. I cannot do much about interest rates, other than react, and I will stay ready, especially if inflation pressures push up rates and the fixed income market offers me a better payoff. With earnings and cash flows, there may be concerns at the market level, but I bet on individual companies, not markets. With those companies, I can do my due diligence to make sure that they have the operating cash flows (not just dividends or buybacks) to justify their valuations. If that sounds like a pitch for intrinsic valuation, are you surprised?

The Market Timing Mirage
Will there be a market correction? Of course! When it does happen, don't be surprised to see a wave of “I told you so” coming from the bubblers. A clock that is stuck at 12 a'clock will be right twice every day and I would urge you to judge these market timers, not on their correction calls, which will look prescient, but on their overall record. Many of them, after all, have been suggesting that you stay out of stocks for the last five years or longer and it would have to be a large correction for you to make back what you lost from staying on the sidelines. Some of these pundits will be crowned as great market timers by the financial press and they will acquire followers. I hope that I don’t sound like a Cassandra but this much I know, from studying past history. Most of these great market timers usually get it right once, let that success get to their heads and proceed to let their hubris drive them to more and more extreme predictions in the next cycle. As an investor, my suggestion is that you save your money and your sanity by staying far away from market prognosticators.

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Datasets
  1. PE ratios from 1960-2016
  2. Shiller CAPE and T.Bond PE (1960-2016)
  3. S&P 500: Earnings, Dividends and Buybacks (2000-2016)
  4. CAPE Market Timing Test

Friday, August 19, 2016

The Bonfire of Venture Capital: The Good, Bad and Ugly Side of Cash Burn!

In my last post on Uber, I noted that it was burning through cash and that this cash burn, by itself, is neither unexpected nor a bad sign. Since I got quite a few comments on what I said, I decided to make this post just about the causes and consequences of cash burn. In the process, I hope to dispel two myths held on opposite ends of the investing spectrum, the notion on the part of value investors, that a high cash burn signals a death spiral for a business and the equally strongly held belief, at the start-up investing end , that a cash burn is a sign of growth and vitality. 

Cash Burn: The what?
Since it is cash burn, not earnings burn, that concerns us, let’s start with the obvious. It is cash flow, not earnings, that is at the heart of a cash burn problem. While many money losing companies have cash burn problems, not all cash burn problems are money losing, and not all money losing companies have a cash burn problem. To understand cash burn, you have to start with a working definition of cash flows and my definition hews closely to what I use in the context of valuing businesses. The free cash flow to the firm is the cash left over after taxes have been paid and reinvestment needs (to maintain existing assets and generate future growth) have been met:

For mature, going concerns, the after-tax operating income and free cash flow to the firm will be positive (at least on average) and that cash flow is used to service debt payments as well as to provide cash flows to equity in the form of dividends and stock buybacks. Any remaining cash flow, after debt payments and dividends/buybacks, augments the cash balance of the company.

But what if the free cash flow to the firm is negative? That can happen either because a company has operating losses or because it has large reinvestment needs or both occur in tandem. If you have negative free cash flow to the firm, you can draw down an existing cash balance to cover that need and if that turns out to be insufficient, you will have to raise fresh capital, either in the form of new debt or new equity. If this negative cash flow is occasional and is interspersed with positive cash flows in other years, as is often the case with cyclical or commodity companies, you consider it to be a reflection of normal operations of the firm and it should cause few issues in valuation. If, on the other hand, a business has negative cash flows year in and year out, it is said to be burning through cash or having a “cash burn” problem.

To measure the magnitude of the cash spending problem, analysts use a variety of measures. One is to compute the dollar cash spent in a time period, usually a month, and that is termed the Cash Burn rate. Another is to compute the Cash Runway, the time period that it will take for a company to run through its existing cash balance. Thus, a firm with a $1 billion cash balance and a negative cash flow of -$500 million a year has a 2-year Cash Runway. In contrast, another company with a $1 billion cash balance and a negative cash flow of -$ 2 billion a year has only a 6-month Cash Runway. 

Cash Burn: The Why?
Looking at the definition of cash flows should give you a quick sense of why you get high cash burn values (and ratios) at some companies. If your company is and has been losing money or generating very small earnings for an extended period and it sees high growth potential in the future (and invests accordingly), your cash flows will reflect that reality. 

That combination of low operating income/operating losses and high reinvestment is what you should expect to see at many young companies and the resulting negative free cash flow to the firm will be the norm rather than the aberration. As the companies move through the life cycle, the benign perspective on cash burn is that this will cease to be a problem.

As the company scales up, its operating income and margins should increase and as growth starts to scale down (in future years), the reinvestment should start dropping. 

Cash Burn: The what next?
The combination of higher operating margins and lower reinvestment should generate a cross over point where cash flows turn positive and these positive cash flow will carry the value. Rather than talking in abstractions, let me use the numbers in my August 2016 Uber valuation to illustrate. The story that I am telling in these numbers is of a going concern and success, with high revenue growth accompanied by improving operating margins as the first leg, followed by declining growth (and reinvestment) converting negative cash flows to positive cash flows in the second leg and a steady state of high earnings and cash flows reflected in a going concern value in the final phase.
In my Uber forecasts, the cash flows are negative for the first six years, with losses in the first five years adding on to reinvestment in those years. The cash flows turn positive in year 7, just as growth starts to slow and accelerate in the final years of the forecasts.  Though these numbers are specific to Uber, the pattern of cash flows that you see in this figure is typical of the good cash burn story.

The life cycle story that I have laid out is the benign one, where after its start-up pains, a young company turns the corner, starts generating profits and ultimately turns cash flows around. Before you buy into the fairy talk that I have told you, you should consider a more malignant version of this story. In this one, the firm starts off as a growth firm with negative margins and high reinvestment (and cash burn). As the revenues increase over time and the company scales up, the cost structure continues to spiral out-of-control and the margins become more negative over time, rather than less. In fact, with reinvestment creating an additional drain on the cash flows, your free cash flow will be negative for extended and very long time periods and you are on the pathway to venture capital hell. To illustrate what the cash flows would look like in this malignant version of cash burn, I revisited the Uber valuation and changed two numbers. I reduced the operating margin (targeted for year 10) from 20% down to 5% (making ride sharing a commoditized business) and increased reinvestment to match a typical US company (by setting the sales to capital ratio to two, instead of three). The effects on the cash flows are dramatic.
The cash flows stay negative over the next ten years. In this scenario, it is very unlikely that Uber will make it to year 10 or even year 5, as capital providers will balk at feeding the cash burn machine?

So, when is cash burn likely to be value destructive or fatal? If the company operates in a market place, where competition keeps pushing product prices down and the costs of delivering these products continue to rise, it is already on a course to report bigger and bigger losses, even before considering reinvestment. If this company reinvests for growth and the product market conditions do not change (i.e., price cutting and rising costs are expected to continue), it is likely that the reinvestment will not deliver the earnings required to justify that investment. Here, there is no light at the end of the tunnel, as negative cash flows will generally become more negative over time and even when they do turn positive, will be insufficient to cover the burden of negative cash flows in earlier time periods.

Cash Burn: So what?
Though stories about young companies and their cash burn problems abound, there are few that try to make the connection between cash burn and value other than to point to it as a survival risk. To make the connection more explicit, it is worth thinking about why and how cash burn affects the value of an enterprise. 
  1. Dilution Effect: A company has to raise cash to burn through it and if that cash is raised from fresh equity, as it inevitably has to be for young growth companies, the existing owners of the business will have to give up some of their ownership of the company. If you are an equity investor, the greater the cash burn in a company, the less of the company you will end up owning, even if it survives and prospers.
  2. Growth Effect: The dilution effect presumes that there are capital providers who will be supply the cash needed to keep the firm going through its cash burn days, but what if that presumption is incorrect? The best case scenario for the firm, when capital dries up, is that it is able to rein in discretionary spending (which will include all reinvestment for growth) until capital becomes available again. In the meantime, though, the company will have to scale back its growth plans.
  3. Distress Effect: The more dangerous consequence of capital drying up for a young firm with negative free cash flows Is that the firm’s survival is put at risk. This will be the case if the company is unable to meet its operating cash flow needs, even after cutting discretionary capital spending to zero. In this scenario, the firm will have to liquidate itself and given its standing, it will have to settle for a fraction of its value as a going concern.
In intrinsic valuation, both of these effects can and should be captured in your intrinsic value. 
  1. The dilution effect manifests itself as negative cash flows in the early years and a drop in the present value of cash flows. For instance, in my Uber valuation, the present value of the expected cash flows for the first seven years, all negative, is $4.4 billion. While the positive cash flows thereafter more than compensate for this, I am in effect reducing the value of Uber by about 20% for these negative cash flows and this reduction can be viewed as a preemptive discounting of my equity stake in the company for future dilution.
  2. When I discount the negative cash flows back to today and assume that Uber has no chance of game-ending failure, I am assuming that Uber has and will continue to have access to capital, partly because of its size and partly because existing investors have too much to lose if the company goes into death throes. If you believe these assumptions to be too optimistic, you can adjust the valuation in two ways. The first is by putting a cap on how much new capital the firm can raise each year, which will also operate as a constraint on future growth. The other is by allowing for a probability that the firm will fail, either because capital markets shut down or cash flows are more negative than expected. In my Lyft valuation in September 2015, for instance, I allowed for a 10% probability of this occurring and assumed that equity investors would get close to nothing if it did, effectively reducing my valuation today.
In pricing, how does it show up? In a young company, pricing usually involves forecasting revenues or earnings in a future time period, applying a multiple, at which you believe the company will be priced by a potential buyer or the market in an IPO, to these revenues and pricing and then discounting back that end price to today using a target rate of return.

As you can see, there is no explicit adjustment for cash burn in this equation. While you could bring in the effect of negative cash flows, just as you did in intrinsic valuation, by discounting them back to today and netting out against the pricing, doing that removes one of the biggest reasons why investors and analysts like pricing, which is that it is simple. The only adjustment mechanism left is the target rate of return and, in my view, it becomes the mechanism that venture capitalists and investors use to deal with cash burn concerns. Given that these target rates of return also carry the weight of reflecting failure risk, it should come as no surprise that VC target rates of return for investment look high (at 30%, 40% or even 50%) relative to rates used for established companies.

An Investor Checklist for Cash Burn
If you are an investor in a company, public or private, that is burning through cash, you may be wondering at this point what you would look at to determine whether a company’s cash burn is benign or malignant and whether it is on a glide path to glory or a Hari Kari mission. Here are some things to consider:
  1. Understand why the company is burning through cash: Looking back at the constituents of free cash flows, there are multiple paths that can lead to negative free cash flows. The most benign scenario is one where a money making company reports negative cash flows because of large reinvestment. Not only is this negative cash flow a down payment for future growth but it is also discretionary, insofar as managers can scale back reinvestment if capital becomes scarce. The most dangerous combination is a money losing company that reinvests very little, since there is little potential for a growth payoff and management will be helpless if capital freezes up.
  2. Diagnose the operating business: While there is often a lot of noise around the numbers, you still have to make your best judgments about the profitability of the underlying business. In particular, you want to focus on the pricing power that your company has and the economies of scale in its cost structure. The most benign scenario on this dimension is one where the company has significant pricing power and a cost structure that benefits from scale, allowing for margin improvement over time.
  3. Gauge management skills: Managing a cash-burning company does require management to keep costs under control, while reinvesting to generate growth and to take care of short term cash flow problems, while mapping out a long term strategy. The best case scenario for investors is that the company is run by a management team that works within the cash flow constraints of today while mapping out pathways to profitability over time. The worst case scenario is that the company is managed by those who view negative cash flows as a badge of honor and a sign of growth rather than a temporary problem to overcome.
  4. Growth/Reinvestment trade off: Since reinvesting for future growth can be a big reason for negative cash flows, to assess the payoff in value terms, you have to both estimate how much growth will be created and its value effect. In its most value-creating form, reinvestment will generate high growth coupled with high returns and its most value-destructive form, reinvestment will drain cash flows while generating low growth and poor profits.
  5. Capital Market A firm with a cash burn problem is more depending upon capital markets for its survival, since a closing of these markets may be sufficient to put the firm into receivership. It is no surprise, therefore, that cash burning companies that have larger cash balances or more established capital providers are viewed more positively than cash burning companies that have less cash and have less access to capital.
This checklist requires subjective judgments along the way and you will be wrong sometimes, in spite of your best efforts. That should not stop you from trying.

The Bottom Line
If you are an investor in a company that is burning through cash, don't panic! If your investments are in young companies, it is exactly what you should expect to see though you should do your due diligence, examining the reasons for the cash burn in and the soundness of the underlying business model. If you are an old-time value investor, weaned on large dividends, positive cash flows and margin of safety, you may find yourself avoiding companies that have these cash burn problems but be glad that there are investors who are less risk averse than you are and willing to bet on these companies.

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Posts on valuing young companies

  1. Blood in the Shark Tank: Pre-money, Post-money and Play-money Valuations
  2. Billion Dollar Tech Babies: A Blessing of Unicorns or a Parcel of Hogs
  3. The Bonfire of Venture Capital: The Good, Bad and Ugly Side of Cash Burn

Wednesday, August 17, 2016

The Ride Sharing Business: Is a Bar Mitzvah moment approaching?


I did a series of three posts on the ride sharing business about a year ago, starting with a valuation of Uber, moving on to an assessment of Lyft, continuing with a global comparison of ride sharing companies and ending with a discussion of the future of the ride sharing business. In the last of those four posts, I looked at the ride sharing business model, argued that it was unsustainable as currently structured and laid our four possible ways in which it could be evolve: a winner-take-all, a losing game, collusion and a new player (from outside). While ride sharing continues its inexorable advance into new markets and new customers, the last few months has also brought a flurry of game-changing actions, culminating with Uber’s decision about a week ago to abandon China to arch-rival Didi Chuxing. It is a good time to take a look at the market again and perhaps map out where it stands now and what the future holds for it.

The Face of Disruption
While there is much to debate about the future of the ride sharing business, there are a few facts that are no longer debatable. 
  1. Ride sharing continues on its growth path: Ride sharing has grown faster, gone to more places and is used by more people than most people thought it would be able to, even a couple of years ago. The pace of growth is also picking up. Uber took six years before it reached a billion rides in December of 2015, but it took only six months for the company to get to two billion rides. For just the US, the number of users of ride sharing services is estimated to have increased from 8.2 million in 2014 to 20.4 million in 2020. 
    YearNumber of US ride sharers (in millions)% of US adult population
    2014
    8.20
    3.40%
    2015
    12.40
    5.00%
    2016
    15.00
    6.00%
    2017
    17.00
    6.70%
    2018
    18.20
    7.10%
    2019
    19.40
    7.50%
    2020
    20.40
    7.80%
  2. It is globalizing fast: In the same vein, ride sharing which started as a San Francisco experiment that grew into a US business has become global in just a short period, with Asia emerging as the epicenter for future growth. Didi Chuang, the Chinese ridesharing company, completed 1.43 billion rides just in 2015 and it now claims to have 250 million users in 360 Chinese cities. Ride sharing is also acquiring deep roots in both India and Malaysia, and is making advances in Europe and Latin America, despite regulatory pushback. 
  3. Expanding choices: The choices in ride sharing are becoming wider, to attract an even larger audience, from carpooling and private bus services to attract mass transit customers to luxury options for more upscale customers. In addition, ride sharing companies are experimenting with pre-scheduled rides and multiple stops on single trip gain to meet customer needs. 
  4. Devastating the status quo: All of this growth has been devastating for the status quo. Even hardliners in the taxicab and old time car service businesses recognize that ride sharing is not going away and that the ways of doing business have to change. The price of a New York city medallion which was in excess of $1.5 million before the advent of ride sharing continues its plunge, dropping to less than $500,000 in March 2016. The price of a Chicago cab medallion, which peaked at $357,000 in 2013, had dropped to $60,000 by July 2016.
In short, there is no question that the car service business as we know it has been disrupted and that there is no going back to the old days. If you own a taxi cab or a car service business, the question is no longer whether you will lose business to ride sharing companies but how quickly, even with the regulatory authorities standing in as your defenders.

A Flawed Business Model
Disruption is easy but making money off disruption is difficult, and ride sharing companies would be exhibit 1 to back up the proposition. While the ride sharing option is here to stay and will continue to grow, ride sharing companies still have not figured out a way to convert ride sharing revenues in profits. In making this statement, though, I am relying on dribs and drabs of information that are coming out of the existing ride sharing companies, almost all of whom are private. Piecing together the information that we are getting from these unofficial and often selective leaked information, here is what seems clear:
  1. Raising capital at a hefty pace: In the last two years, the ride sharing companies have been active in raising capital, with Uber leading the way and Didi Chuxing close behding. In the graph below, I list the capital raised collectively by players in the ride sharing business over the last three years and the pricing attached to each company in its most recent capital round.
  2. Ride Sharing Company
    Amount Raised in last 12 months (in millions)
    Investor
    Company Priced at (in millions)
    Didi
    $7,300.00
    Apple, Alibaba, Softbank & Others
    $28,000
    Uber
    $3,500.00
    Saudi Arabian Sovereign Fund
    $62,500
    Lyft
    $500.00
    GM
    $5,500
    Ola
    $500.00
    Didi & Existing Investors
    $5,000
    Grabtaxi
    $350.00
    Didi & CIC
    $1,800
    Gett
    $300.00
    Volkswagen
    $2,000
    Via
    $100.00
    VC
    NA
    Scoop
    $5.10
    BMW
    NA
  3. At rich prices: As the table above indicates, the investors who are putting money in the ride sharing companies are willing to pay hefty prices for their holdings, with no signs of a significant pullback (yet). Uber, at its current pricing, is being priced higher than Ford or GM. Note that I use the word “pricing” to indicate what investors are attaching as numbers to these companies because I don’t believe that they have the interest or the stomach to actually value them. If you are confused about the contrast between “value” and “price”, please see my blog post on the topic.
  4. From unconventional capital providers: The capital coming into ride sharing companies is  coming less from the traditional providers to private businesses and more from public investors (Mutual funds, pension funds, wealth management arms of investment banks and sovereign funds). The reasons for the shift are simple on both sides. Public investors want to be invested in the ride sharing companies because they have visions of public offerings at much higher prices and are afraid to be left on the side lines, if that happens. The ride sharing companies are for it because some of them (Uber and Didi, in particular) are getting too big for venture capitalists to capitalize and perhaps because public investors are imposing less onerous constraints on them for providing capital.
  5. While burning through cash quickly: As quickly as the capital is being raised at ride sharing companies, it is being spent at astonishing rates. Uber admitted that it burned through more than a billion dollars in cash in 2015, with a significant portion of that coming from its attempts to increase market share in China. Its competitors are matching it, with Lyft estimated to be burning through about $50 million in cash each month ($600 million over a year) and Didi Chuxing's CEO, Jean Liu, openly admitting that “We wouldn’t be here today if it wasn’t for burning cash”. 
The cash burn at ride sharing companies, by itself, is neither uncommon nor, by itself, troubling After all, to grow, you have to spend money, and a young start up often loses money because of infrastructure investments and fixed costs, and as revenues climb, margins should improve and reinvestment should scale down (at least on a proportional basis). The problem with ride sharing is companies in this business are losing money only partially because of their high growth. In fact, I believe that a significant portion of their expenses are associating with maintaining revenues rather than growing them (ride sharing discounts, driver deals and customer deals). I am afraid that I cannot back up that statement with anything more tangible than news stories about ride sharing wars for drivers, big discounts for customers and the leaked statistics from the ride sharing companies.  In effect, it looks like the business model that has brought these companies as far as they have in such a short time period are flawed, because what allowed these companies to grow incredibly fast is getting in the way of converting revenues to profits, since there are no moats to defend.

If you are skeptical about my contention, here is a simple test of whether the cash burn is just a consequence of going for high growth or symptomatic of a business model problem. Assume that the growth ends in the ride sharing business tomorrow and that the ride sharing companies were to compete for existing riders. Do you think that the pieces are in place for these companies to generate profits? I don't think so, as ride prices keep dropping, new ride sharing businesses pop up and the costs continue to increase. 

The Bar Mitzvah Moment
In a post in November 2014 on Twitter’s struggles, I argued that every young growth company has a bar mitzvah moment, a time in its history when markets shift their attention away from surface measures of growth (number of users, in the case of Twitter) to more operating substance (evidence that the users are being monetized). I also argued that to get through these bar mitzvah moments successfully, young growth companies have to be managed on two levels, delivering the conventional metrics on one level while working on creating a business model to convert these metrics into more conventional measures of business success (revenues and earnings) on the other.

This may be premature but I have sense that the bar mitzvah moment has arrived or will be arriving soon for ride sharing companies. After an initial life, where investors have been easily sated with reports of more ridesharing usage (number of cities served, rides, drivers etc.), these investors are starting to ask the tough questions about how ride sharing companies propose turning these impressive usage statistics into profits. What’s driving investor uneasiness?

  • The first factor is that the public investors who have put their money into the ride sharing companies operate under shorter time horizons than many VC investors and the fact that an IPO is not imminent in any of these companies adds to their impatience to see tangible results. 
  • The second factor is that the belief that there will be a winner-take-all, who can then proceed to charge what the market will bear, has receded, as all of the players in the market continue to attract capital. 
  • The third factor is that the possibility that big players like Apple and Google will enter the market is becoming a plausibility and perhaps even a probability and their technological edge and deep pockets could put existing ride sharing companies at a disadvantage.
In my view, it is this perception that change is coming that is leading the flurry of activity that we have seen at ride sharing companies in the last few months. In conventional business terms, the ride sharing companies are trying to shore up their business models, generate pathways to profitability and build competitive advantages. Broadly speaking, these efforts include the following:
  1. Increased Switching costs: The ride sharing companies are working on ways to increase the costs of switching to their competitors, both among drivers (who I described in a prior post as uncontracted free agents) and customers. Uber’s partnership with Toyota, where Toyota will lease cars on favorable terms to Uber drivers, will benefit drivers but will also bind them more closely to Uber, and make it more difficult for them to threaten to go to Lyft for a few thousand dollars. GM’s agreement with Lyft is not as specific but seems to be directed at the same objective. 
  2. Cooperation/Collusion: In my ride sharing post in October 2015, I raised the possibility that the ride sharing companies would follow the route of the Mafia in the United States in the middle of the last century, where crime families divided the US into fiefdoms and agreed not to invade each other’s turf. Uber’s decision to abandon the Chinese market to Didi in return for a 20% ownership stake in that company, in particular, seems to be designed to accomplish this no-compete objective. Uber’s China move specifically seems to be designed to stop the mutually assured destruction that a free-for-all fight with Didi will create. 
  3. Higher Capital Intensity: Though there is little that is tangible that I can point to in support of this notion, I think that the ride sharing companies now recognize that their absence of tangible assets and infrastructure investment can now operate as an impediment to building a sustainable business. Consequently, I will not be surprised to see more investment by the ride sharing companies in self-driving cars, robots and other infrastructure as part of the phase of building up business moats.
As we witness the breakneck pace of change in the ride sharing business, the big question if you are considering investing in these companies is whether these actions will work in laying the groundwork for profitability. Well, yes and no. If the ride sharing business were frozen to include only the current players, it is probable that they will come to an uneasy agreement that will allow them to generate profits. The problem, though, is that the existing structure of this business is anything but settled, with new ride sharing options popping up and large technology companies rumored to be on the cusp of jumping in. The unquestioned winners in the ride sharing game are car service customers, who have seen their car service costs go down while getting more care service options. . 

Uber: An updated valuation
In September 2015, I valued Uber at $23.4 billion, based upon my reading of the market then. In assessing this value, I incorporated what I saw as Uber’s strengths (its reach globally and across many different businesses) and its weaknesses (an out-of-control cost structure and the elimination of many of the insurance and regulatory loopholes that allowed ride sharing to gain such an advantage over conventional car service).  In the last year, as I see it, here is how the fundamental story has been impacted by developments in the last year: 

  1. Revenues: Uber’s growth continues, measured in cities and rides, though the rate of growth has started to slow down, not surprising given its size. Its decision to leave China, the largest ride sharing market in the world, even if it was the right one from the perspective of saving itself from a cash war, will reduce its potential revenues in the future.
  2. Competition: Before you over react to Uber's exit from China, there is good news in that decision. First,by removing the costs associated with going after the China market from the equation, it reduces the problem of cash burn, at least for the near future. Second, its peace treaty with Didi Chuxing puts the smaller players at risk. Lyft, Ola and Grabtaxi, all companies that Didi invested in to stop the Uber juggernaut, may now be left exposed to competition. Third, in return for its decision to leave the China market, Uber does get a 20% stake in Didi Chuxing.
  3. Costs: On the cost front, the ride sharing business continued to evolve, with most of the changes signaling higher costs for the ride sharing companies in the future. Seattle's decision to let Uber/Lyft drivers unionize may be the precursor of similar developments in other cities and higher costs for both companies. On the legal front, cities continue to throw up roadblocks for the ride sharing companies. Uber and Lyft abandoned Austin, after the city passed an ordinance requiring drivers for both services to pass background checks. One symptom of these higher costs is in the leaked financials from Uber, which suggested that the company lost more than a billion dollars in the first half of 2015. 
  4.  Imminent competition: The Silicon Valley gossip continues about Apple and Google preparing to enter the ride sharing market, with Google announcing that it has entered into a partnership with Fiat and that a top robocist had left the self-driving car unit a few days ago. Never one to hide in the shadows, Elon Musk added car sharing to his long list of to dos at Tesla in his Master Plan for the company. It seems clear that while the timing of the change remains up in the air, change is coming to this business.
None of the changes are dramatic but tweaking my valuation to reflect those changes, as well as changes in the macro environment in the last year, my updated valuation for Uber is $28 billion, a little higher than my estimate last year of $23.4 billion. The loss of the China market reduces the total market size but it is offset by a higher market share of the remaining market and a 20% stake in Didi Chuxing. The pricing attached to this Didi stake is $7 billion, but since the same forces that have elevated Uber's pricing are at play across the ride sharing market, I have attached a value of $5 billion to the stake. The picture of the valuation is below:
Download spreadsheet
Clearly, the Saudi Sovereign fund, Goldman Sachs and Fidelity would disagree with me, since their estimated pricing for Uber is more than double my value. They could very well be right in their judgment and I could be wrong, but my valuation reflects my story about the company, which is perhaps not as expansive nor as optimistic as the stories that they might be telling.

What's next?
The ride sharing business is in a state of flux and the next few months will bring more experimentation on the part of companies. Some of these experiments will be with the services offered but more of them will be attempts to get business models that work at converting riders to profits. The ride sharing companies have clearly won the first phase of the disruption battle with the taxicab and car service companies and have been rewarded with high pricing and plentiful capital. The next phase will separate the winners from the losers song the ride sharing companies and it is definitely not going to be boring.

Update:  To the many people who have commented about this valuation, I thank you, even if you vehemently disagree with me. To give you some sense of what the feedback has been across my blog, email and twitter, more of you seem to think that I am being too optimistic than pessimistic about Uber's future. Whatever your point of view, I don't claim to have a monopoly on the right story for each company that I value in this blog and the resulting valuation. However, rather than take issue with what you think is wrong with my story/valuation, I would suggest that you download the spreadsheet that is attached and make it your story/valuation. Thus, if you believe that my total market size is too low and/or that my judgment on profit margins too pessimistic, replace them with your own and you will have your own valuation of Uber. 

YouTube Video


Last year's posts on ride sharing
  1. On the Uber Rollercoaster: Narrative Tweaks, Twists and Turns
  2. Dream Big or Stay Focused? The Lyft Answer!
  3. The Future of Ride Sharing: Playing Pundit

Uber Valuations
  1. June 2014
  2. September 2015
  3. August 2016

Monday, August 15, 2016

Investing and Valuation Lessons from the Renaissance

I just got back a few days ago from a two-week family holiday in Italy, where we spent the bulk of the second week in Florence, which we used as a springboard to see Tuscany. I kept away from work through much of the period, though I did check my emails once in a while and even tried answering a few on my iPhone, where my awful typing skills restricted me to one-sentence responses. So, if you were one of those people that I responded to, I apologize if I seemed brusque. That said, I am also afflicted with a disease of seeing connections between everything I see around me and investing, and this vacation was no exception. Thus, in Florence, as I gazed at Brunelleschi’s magnificent Duomo on the Cathedral and marveled at the beauty of Michelangelo’s David, I could not help but think about how much we (as investors) can learn from those renaissance geniuses.


The Story of Brunelleschi’s Dome
If you have visited Florence or even read about the dome on its cathedral, I am sure that you have heard its story. The construction of the cathedral was begun in 1296 and continued in fits and starts through much of the next few decades with the Plague bringing it to a standstill in the second half of the fourteenth century. The centerpiece of the cathedral was to be its freestanding dome, but since architects of the age lacked the capacity to build one large enough to cover the church, it was left for another generation to complete. In 1418, two goldsmiths in Florence, Lorenzo Ghiberti and Filippo Brunelleschi, competed in a contest for designing the dome, with Brunelleschi winning by a hair. Brunelleschi spent time studying the Pantheon in Rome, a concrete dome built more than a thousand years prior, but one where all records of its construction had long been destroyed. He started work on his Duomo in 1420 and completed it by 1436, and the result speaks for itself:


Brunelleschi was an artist, skilled in its many forms, but to build the dome, he not only drew on science but actively used it to solve practical problems. To allow the huge dome to stay standing without visible supports, Brunelleschi came up with the ingenious concept of a dome within a dome (a double shell) and stone ribs designed to defend against the spreading created by the weight of the dome. He had to construct hoisting machines to lift the almost four million bricks and large stones and structural innovations to let workers complete the construct. The dome, once completed, was as much an engineering feat as it was an artistic triumph and it remains so today.

Investing and Valuation Lessons
I can think of at least three big lessons that investors can learn from the Renaissance masters. The first is the meaning of faith, a scarce resource in today's markets, as we eagerly seek confirmation that we are right in market movements and are quick to give up, when things don't go our way. The second is the need for humility, an acceptance that much of what we claim to be new and innovative in investing is neither, and that we can learn from looking at the past. The third is that just as the best of the Renaissance required a melding of art and science, the best of investing is built on a combination of story telling and number crunching. 

Lesson 1: The Importance of Faith
Investing is as much about faith as it is about mechanics. As our access to data and models increases, I will borrow words that Tom Friedman used in a different context, and argue that the investing world is becoming flatter. It is not getting any easier to make money from investing and one reason may be that we have no faith in either our ability to attach values to companies, in the face of uncertainty, or in the market’s capacity to correct its mistakes. As a consequence, even those investors who are well versed in valuation mechanics are generally unwilling to act on the valuations that they generate, or when they do, to hold on to them in the face of adversity.  Like many of you, I find myself getting impatient when the stock price does not correct quickly towards my estimated value on my investments and growing uncertain with my own judgment, if the divergence persists for months. As I looked up at the Florence skyline and pondered the patience of those who were willing to build a church first and then wait almost a hundred for someone to come along with its dome, I understood the meaning of faith and how far I have to go to get there.

Lesson 2: There are no new investment lessons, just old ones to relearn
With superior resources and better investment education, we tend to think that we are not only more sophisticated than investors in prior generations but less likely to make the same errors in judgment. If only that were true! Just as the skills that allowed the Romans to build the Pantheon were forgotten for a thousand years and had to be rediscovered by Brunelleschi, there are simple lessons that investors learned in past markets that we seem to forget in new markets. Each time we make collective mistakes as investors and there is a market correction, we are quick to say "never again" only to repeat the same mistakes a few years later. 

Lesson 3: Art and Science
Are you an artist or a scientist? An engineer or a poet? We live in an age where we are asked to pick sides and told that the two cannot co-exist. In the context of valuation, the battle is fought out between the story tellers and the number crunchers, with each claiming the high ground. In the last few years, I have argued not just for a truce between the two sides but also for more engagement,  a marriage of numbers and narrative in valuation and investing. Even my best efforts pale in comparison to one look at Brunelleschi’s dome, since he understood that there was no divide between art and science. It is a lesson that we seem to have forgotten over time, as we force people to choose sides in a battle where there are no winners.

An Investment Renaissance
We live in an age of specialists, and in investments, this has taken the form of experts who operate in silos, option traders who act as if their derivative securities can exist without their underlying assets, fixed income investors who function as if bonds are the only game in town and equity investors who can only talk about stocks. This specialization comes with consequences and one of them is that we tend to operate in echo chambers, talking to people who think like us, act like us and not surprisingly, agree with us. If the words "Renaissance man (or woman)" are used to describe someone whose expertise spans different subject areas, in the context of investing, I would use those words to refer to those investors who can move with ease across markets and are just as comfortable with stories as they are with numbers. This is my subjective judgment but I think that there used to be more of them three decades ago, when I started in investing, and they seem to become rarer by the day.  In corporations, banks, money management units, consulting firms and even in academia, we could use more Renaissance thinking.

YouTube Video

Friday, July 22, 2016

May you live in "exciting" times! An Updated Picture of Country Risk

About a year ago, I completed my first  update of a paper looking at all aspects of country risk, from political risk to default risk to equity risk, and wrote about my findings in three posts, one on how to incorporate risk in company value, the second on the pricing of country risk and the last one on decoding currencies. The twelve months since have been interesting, to say the least, and unsettling to many as markets were buffeted by crises. In August 2015, a month after my posts, we had questions about China, its economy and markets play out on the global arena, leading to this post with my China story. Towards the end of June 2016, we had UK voters choosing to exit the EU, and that too caused waves (or at least ripples) through markets, which I talked about in this post. It is a good time to update my global country risk database and the paper that goes with it, and in this post, I would like to focus on updating numbers and providing risk pictures of the world, as it looks today.

Country Risk: Non-market measures
This should go without saying, but since there is still resistance in some practitioner circles to this notion, I will say it anyway. Some countries are riskier to invest in, either as an investor or as a business, than others. The risk differences can be traced to a variety of factors including where the country is in the life cycle (growing, stable or declining?), the maturity of its political institutions (democracy or dictatorship?, smoothness of political transitions), the state of its legal system (in terms of both efficiency and fairness) and its exposure to violence. Not surprisingly, how you perceive risk differences will depend in large part on which dimension of risk you are looking at in a country.

While I look at risk measures that look at threat of violence, degree of corruption, dependence of the economy on a commodity (or commodities) and protection of property rights individually in the full paper, I also report on a composite measure of risk that I obtain from Political Risk Services (PRS), a Europe-based service that measures country risk on a numerical scale, with lower (higher) numbers representing more (less) risk. The picture provides a heat map of the world using this measure as of July 2016. (The heat maps don't seem to show up on some browsers. So, I have replaced them with snapshots. If you click on the links below the snapshots, you should be able to see the heat maps.. I think).
Link to heat map

As we move from 2015 to 2016, it is interesting to see how much risk changed in countries, rather than the level of risk, and again using political risk score, the heat map above reports on changes in the PRS score over the last year (if you hover over a country, you should see it).

Finally, there is an alternate and more widely used measure of country risk that focuses on country default risk, with sovereign ratings for countries from Moody's and Standard & Poors (among others) and the picture below provides these ratings, as of July 1, 2016, globally:
Link to heat map
I know that ratings agencies are much maligned after their failures during the 2008 crisis, but I do think that some of the abuse that they take is unwarranted. They often move in tandem and are generally slow to respond to big risk shifts, but I am glad that I have their snapshots of risk at my disposal, when I do valuation and corporate finance.

Country Risk: Market Measures
There are two problems with non-market measures like risk scores or sovereign ratings. The first is that they are neither intuitive nor standardized. Thus, a PRS score of 80 does not make a country twice as safe as one with a PRS score of 40. In fact, there are other services that measure country risk scores, where high numbers indicate high risk, reversing the PRS scoring. The second is that these non-market measures are static. Much as risk measurement services and ratings agencies try, they cannot keep up with the pace of real world developments. Thus, while markets reacted almost instantaneously to Brexit by knocking down the value of the British Pound and scaling down stock prices around the globe, changes in risk scores and ratings happened (if at all) more slowly.

The first market measure of country risk that I would like to present is one that captures default risk changes in real time, the sovereign credit default swap (CDS) market. The heat map below captures sovereign CDS spreads globally, as of July 1, 2016:
Link to heat map
Note that the map, if you scroll across countries,  reports three numbers: the CDS spread as of July1, 2016, a CDS spread net of the US CDS (of 0.41%) as of July 1, 2016 and the in the sovereign CDS spread over the last twelve months. Reflecting the market's capacity to adjust quickly, the UK, for instance, saw a doubling in the market assessment of default risk over the last year. The limitation is that sovereign CDS spreads are available for only 64 countries, with more than half of the countries in the world, especially in Africa, uncovered.

The second market measure of country risk is one that I have concocted that is based upon the default spread, but also incorporates the higher risk of equities, relative to government bonds, i.e., an equity risk premium (ERP) for each country. The process by which I estimate these equity risk premiums, which I build on top of a premium that I estimate every month for the S&P 500 (and by extension, use for all AAA ratted countries), is described more fully in this post from the start of the year. The updated ERPs for countries is captured in the heat map below.
Link to heat map
Note that as companies globalize, you need the entire map to estimate the equity risk premium  to value or analyze a multinational, since its risk does not come from where it is incorporated but where it does business.

Conclusion
I think that the way we think about and measure country risk is in its nascency and that we need richer and more dynamic measures of that risk. I don't claim to have all of the answers, or even most of the answers, but I will continue to learn from market behavior and make my equity risk premiums more closely reflective of the risk in each country. I will probably regret this resolution next July, but I plan to make my country risk premium an annual update, just as I have my work on equity risk premiums.

Charts update: The charts don't seem to be working on some browsers. They seem to work on Safari.

Papers
  1. Country Risk Premium: Determinants, Measures and Implications - The 2016 Update
Data)
  1. Sovereign Ratings, by Country (July 2016)
  2. Sovereign CDS Spreads, by Country (July 2016)
  3. Equity Risk Premiums, by Country (July 2016)
Last year's Posts on Country Risk

    Thursday, July 14, 2016

    Tesla: It's a story stock, but what's the story?

    The last few weeks have tested Tesla’s shareholders and frustrated short sellers in the stock. Shareholders have had to weather a series of bad news stories, ranging from a failure to meet its shipment targets in the last few months to a fatality with a driver using its autopilot function to a surprise acquisition of Solar City. While each of those stories has created pressure on the stock, the price has held up surprisingly well, frustrating long-time short sellers who have been waiting for a correction in what they see as an overhyped stock.
    Tesla Stock Price: Google Finance
    So, what gives here? Why has Tesla’s stock price not collapsed facing this adversity? I think that Tesla's price action illustrates the power of the “big story” and the sometimes difficult-to-understand market dynamics of story stocks.

    Story Stocks
    In earlier posts, I have made a case for valuation being a bridge between story and numbers, with every number telling a story and every story being captured in a number. Thus, while your final valuation may be composed of forecasts of revenue growth, profit margins and reinvestment, it is the story that binds together these numbers that represent the soul of the valuation.

    That said, the balance between stories and numbers can vary across companies and for the same company, can change across time. For most companies, it is the story that comes first, with numbers following, and for others, it is the numbers that tell the story. 

    There are some companies that I would classify as story stocks, where the story is so dominant in both how people price the stock and what determines its value that the numbers either fade into the background or have only a secondary effect. There are three characteristics that story stocks share:

    Amazon remains one of my longest-standing examples of a story stock, a company, with a CEO (Jeff Bezos) who was and continues to be clear about his ambitions to conquer big markets, told that story well and acted consistently with it. You can see why Tesla also has the makings of a story stock, going after a big market (automobiles and perhaps even clean energy), with an unconventional strategy for that market and a larger-than-life CEO in Elon Musk. With story stocks, it is the story that dominates how the market perceives the stock, and that has consequences:
    1. Story changes and information: it is shifts in the story that cause price and value changes. An earnings report that beats expectations (in either direction) or a news story of significance (good or bad) may not have any effect on either (value or price) if it does not change the story. Conversely, a shift in perceptions about the business story, triggered by minor news or even no news at all, can trigger major price changes. 
    2. Wider disagreements: When a company’s value is driven primarily by numbers, there is less room for disagreement among investors. Thus, when valuing a company in a market with steady revenue growth and sustainable profit margins, there will be less divergence in what investors think the stock is worth. In contrast, with a story stock, investor stories can span a much wider spectrum, leading to a much bigger range in values, as illustrated with Uber in this post
    The key to understanding story stocks is deciphering the story behind the company, then checking that story for reasonability and making it your own.

    The Tesla Story
    So, what is Tesla’s story? To structure the process, let me lay out the dimensions where investors can differ on the story and how these differences play out valuation. The first is Tesla's business, i.e., whether you see Tesla primarily as an automobile company that incorporates technology into its cars, a technology company that uses automobiles to deliver superior electronics (battery and software) or even a clean energy company with its focus on electric cars. The second is focus,  i.e., whether you believe that Tesla will cater more to the high end of whichever business you see it in or have mass market appeal. The third is the competitive edge that you see it bringing to the market, with the choices ranging from being first to the market, superior styling & brand name and superior (proprietary) technology. The fourth is the investment intensity needed to deliver your expected growth, with much higher reinvestment needed if you consider Tesla a conventional manufacturing company (like autos) than if you see it as a tech company. Finally, there is the risk in the company, with the auto story bringing with it the risks of cyclicality and high fixed costs and the tech story the risks of being rendered obsolete by new technologies and shorter life cycles.


    The value that you attach to Tesla will be very different if you consider it to be an automobile company, catering to a high-end clientele than if you view it as an electronics company with a superior technology (in electric batteries) and a mass market audience.

    My thinking on Tesla has changed over time. In my first valuation of the company in September 2013, I valued it as a high-end automobile company, which would use its competitive edges in branding and technology to generate high margins, with investment and risk characteristics more reflective of being an auto than a tech company. The resulting inputs into my valuation and valuation are summarized below:
    Download spreadsheet
    The value that I obtained for Tesla’s equity was $12.15 billion (with a value per share of $70) well below the market capitalization of $28 billion (and a stock price of $168.76) at the time.

    In July 2015 I took another look at Tesla, keeping in mind the developments since September 2013. The company had not only sent signals that it was moving towards offering vehicles with lower price tags (expanding towards the mass market) but also made waves with its plans for a $5 billion gigafactory to manufacture batteries. The focus on batteries suggested to me that I had understated the role that technology played in Tesla’s appeal and I incorporated it more strongly into my story. Tesla remained an automobile company, but with a much stronger technology component and wider market aspirations, which in turn led the following inputs into value:
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    The value of equity based on these inputs was 19.5 billion (share price of $123), much higher than my September 2013 estimate, but still below the value of $33 billion (share price of $220) at the time.

    I took my third shot at valuing Tesla about two weeks ago,  just prior to its Solar City acquisition announcement, and I incorporated the news since my last valuation. The announcement of the Tesla 3 clearly reinforced my story line that it was moving towards being more of a mass market company. The unprecedented demand for the car, with close to 400,000 people putting down deposits for a vehicle that will not be delivered until 2018, indicates the hold that it has on its customer base. I have tweaked the inputs to reflect these changes:
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    The value of equity that I obtained was $25.8 billion (with a share price of $151/share), climbing from my July 2015 valuation but the market capitalization stayed at $33 billion. Before I embark on looking at how the Solar City acquisition and Musk's master plan have on the narrative, it is worth looking at how the value changes as a function of revenues, reinvestment and profit margin:
    Download spreadsheet
    Note that there are pathways that lead to the value at or above the current stock price but they all require navigating a narrow path of building up sales, earning healthy profit margins and reinvesting more like a technology company than an automobile company.

    So, what effect does acquiring Solar City have on the story? If nothing else, it muddies up the waters substantially, a dangerous development for a story stock and that is perhaps even why even long-term Tesla bulls and nonplussed. The most optimistic read is that  Tesla is now a clean energy company, with a potentially much larger market, but the catch is that Solar City's products don't have the cache that Tesla cars have as well as the competitive nature of the solar power market will push margins down. If you add the debt burden and reinvestment needs that Solar City brings into the equation, Tesla, already stretched in terms of cash flows, may be over extending itself. The most pessimistic read is that talk of synergy notwithstanding, this acquisition is more about Musk using Tesla stockholder money to preserve his legacy and perhaps get back at short sellers in Solar City.

    The X Factor: Elon Musk
    The Solar City acquisition spotlighted how difficult it is to separate Tesla, the company, from Elon Musk. Musk's strengths, and there are many, are at the core of Tesla's success but his weaknesses may hamstring the company.
    • On the plus side, Musk clearly fits the visionary mode, dreaming big, convincing customers, employees and investor to buy into his dreams and, for the most part, working on making the dreams a reality. Like Bezos at Amazon and Steve Jobs at Apple, Musk had the audacity to challenge the status quo. 
    • On the minus side, Musk is less disciplined and focused than Bezos, whose story about Amazon has remained largely unchanged for almost 20 years, even as the company has expanded into new businesses and markets. In fact, as someone who has followed Apple for more than three decades, it seems to me that Musk shares more characteristics with Steve Jobs in his first iteration at Apple (which ended with him being fired) than he does with Steve Jobs in his second stint at the company. Musk is a large social media presence, but he does strike me as thin skinned, as his recent exchange with Fortune magazine about the autopilot fatality showed. 
    Your views on  what you think Tesla is worth will be a function of what you think about Elon Musk. If you believe, as some of his most fervent defenders do, that he is that rarest of combinations, a visionary genius who will deliver on this vision, you will find Tesla to be a good buy. At the other extreme, you consider him a modern version of P.T. Barnum, a showman who promises more than he can deliver, you will view Tesla as over valued. Wherever you fall in the Musk continuum, Tesla is approaching a key transition point in its life, a bar mitzvah moment so to speak, where the focus will shift from the story to execution, from master plans to supply chains, and we will find out whether Musk is as good at the latter as he is in the former.

    Can Musk the visionary become Musk the builder? He certainly has the capacity. After all, if you can get spaceships into outer space and back to earth safely, you should be able to build and deliver a few hundred thousand cars, right? Given Tesla's missteps on delivery and execution, though, Musk may not have the interest in the nitty gritty of operations, and if he does not, he may need someone who can take care of those details, replicating the role that Tim Cook played at Apple during Steve Job's last few years at the company.  

    Investment Direction
    Tesla is a company where there seems to be no middle ground. You are either for the company or against it, believe that it is on a pathway to being the next Apple or that it is worth nothing, a cheerleader or a doomsdayer. I think that both sides of this debate are over reaching. I don't buy the talk that Tesla is on its way to being the next trillion dollar company, especially since I have a tough time justifying its current valuation of $33 billion. Unlike some of the high-profile short sellers who seem to view Tesla as an over-hyped electric car company that is only a step away from tipping into default, I do believe that Tesla has a connection to its customers (and investors) that other auto companies would kill to possess, brings a technological edge to the game and has viable, albeit narrow, pathways to fair value.  I will choose to sit this investment out, letting others who are more nimble than I am or have more conviction than I do to take stronger positions in Tesla.

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    1. Tesla (September 2013) valuation
    2. Tesla (July 2015) valuation
    3. Tesla (July 2016) valuation