Interest Rates and Stock Prices: It's Complicated!

Jerome Powell, the new Fed Chair, was on Capitol Hill on February 27, and his testimony was, for the most
part, predictable and uncontroversial. He told Congress that he believed that the economy had strengthened
over the course of the last year and that the Fed would continue on its path of "raising rates". Analysts have
spent the next few days reading the tea leaves of his testimony, to decide whether this would translate into
three or four rate hikes and what this would mean for stocks. In fact, the blame for the drop in stocks over
the last four trading days has been placed primarily on the Fed bogeyman, with protectionism providing an
assist on the last two days. While there may be an element of truth to this, I am skeptical about any Fed-
based arguments for market increases and decreases, because I disagree fundamentally with many about
how much power central banks have to set interest rates, and how those interest rates affect value.

1. The Fed's power to set interest rates is limited

I have repeatedly pushed back against the notion that the Fed or any central bank somehow sets market
interest rates, since it really does not have the power to do so. The only rate that the Fed sets directly is
the Fed funds rate, and while it is true that the Fed's actions on that rate send signals to markets, those
signals are fuzzy and do not always have predictable consequences. In fact, it is worth noting that the Fed
has been hiking the Fed Funds rate since December 2016, when Janet Yellen's Fed initiated this process,
raising the Fed Funds rate by 0.25%. In the months since, the effects of the Fed Fund rate changes on long
term rates is debatable, and while short term rate have gone up, it is not clear whether the Fed Funds rate
is driving short term rates or whether market rates are driving the Fed.

It is true that post-2008, the Fed has been much more aggressive in buying bonds in financial markets in its
quantitative easing efforts to keep rates low. While that was started as a response to the financial crisis of
2008, it continued for much of the last decade and clearly has had an impact on interest rates. To those
who would argue that it was the Fed, through its Fed Funds rate and quantitative easing policies that kept
long term rates low from 2008-2017, I would beg to differ, since there are two far stronger fundamental
factors at play - low or no inflation and anemic real economic growth. In the graph below, I have the treasury
bond rate compared to the sum of inflation and real growth each year, with the difference being attributed
to the Fed effect:

You have seen me use this graph before, but my point is a simple one. The Fed is less rate-setter, when it
comes to market interest rates, than rate-influencer, with the influence depending upon its credibility. While
rates were low in the 2009-2017 time period, and the Fed did play a role (the Fed effect lowered rates by
0.77%), the primary reasons for low rates were fundamental. It is for that reason that I described the Fed
Chair as the Wizard of Oz, drawing his or her power from the perception that he or she has power, rather
than actual power. That said, the Fed effect at the start of 2018, as I noted in a post at the beginning of the
year, is larger than it has been at any time in the last decade, perhaps setting the stage for the tumult in
stock and bond markets in the last few weeks.

To examine more closely the relationship between moves in the Fed Funds rate and treasury rates, I
collected monthly data on the Fed Funds rate, the 3-month US treasury bill rate and the US 10-year treasury
bond rate every month from January 1962 to February 2018. The raw data is at the link below, but I
regressed the changes in both short term and long term treasuries against changes in the Fed funds rate in
the same month:

Looking at these regressions, here are some interesting conclusions that emerge:
1. Short term T.Bill rates and the Fed Funds rate move together strongly: The result backs up
the intuition that the Fed Funds rate and the short term treasury rate are connected strongly, with
 an R-squared of 56.5%; a 1% increase in the Fed Funds rate is accompanied by a 0.62% increase
in the T.Bill rate, in the same month. Note, though, that this regression, by itself, tells you nothing
about the direction of the effect, i.e., whether higher Fed funds rates lead to higher short term
treasury rates or whether higher rates in the short term treasury bill market lead the Fed to push up
the Fed Funds rate.
2. T.Bond rates move with the Fed Funds rate, but more weakly: The link between the Fed
Funds rate and the 10-year treasury bond rate is mush weaker, with an R-squared of 6.7%; a 1%
increase in the Fed Funds rate is accompanied by a 0.19% increase in the 10-year treasury bond
rate.
3. T. Bill rates lead, Fed Funds rates lag: Regressing changes in Fed funds rates against
changes in T.Bill rates in the following period, and then reversing direction and regressing changes
in T.Bill rates against changes in the Fed Funds rate in the following period, provide clues to the
direction of the relationship. At least over this time period, and using monthly changes, it is changes
in T.Bill rates that lead changes in Fed Funds rates more strongly, with an R squared of 23.7%, as
opposed to an R-squared of 9% for the alternate hypothesis. With treasury bond rates, there is no
lagged effect of Fed funds rate changes (R squared of zero), while changes in T.Bond rates do
predict changes in the Fed Funds rate in the subsequent period. The Fed is more a follower of
markets, than a leader.
The bottom line is that if you are trying to get a measure of how much treasury bond rates will change over
the next year or two, you will be better served focusing more on changes in economic fundamentals and
less on Jerome Powell and the Fed.

2. The relationship between interest rates and stock market value is complicated
When interest rates go up, stock prices should go down, right? Though you may believe or have been told
that the answer is obvious, that higher interest rates are bad for stock prices, the answer is not straight
forward. To understand why people are drawn to the notion that higher rates are bad for value, all you need
to do is go back to the drivers of stock market value:

As you can see in this picture, holding all else constant, and raising long term interest rates, will increase
the discount rate (cost of equity and capital), and reduce value. That assessment, though, is built on the
presumption that the forces that push up interest rates have no effect on the other inputs into value - the
equity risk premium, earnings growth and cash flows, a dangerous delusion, since these variables are all
connected together to a macro economy.

Note that almost any macro economic change, whether it be a surge in inflation, an increase in real growth
or a global crisis (political or economic) affects earnings growth, T.Bond rates and the equity risk premiums,
making the impact on value indeterminate, until you have worked through the net effect. To illustrate the
interconnections between earnings growth rates, equity risk premiums and macroeconomic fundamentals,
I looked at data on all of the variables going back to 1961:

The co-movement in the variables and their sensitivity to macro economic fundamentals is captured in the
correlation table. Higher inflation, over this period, is accompanied by higher earnings growth but also
increases equity risk premiums and suppresses real growth, making its net effect often more negative than
positive. Higher real economic growth, on the other hand, by pushing up earnings growth rate and lowering
equity risk premiums, has a much more positive effect on value.

3. Value has to be built around a consistent narrative

In my post from February 10, right after the last market meltdown, I offered an intrinsic valuation model for
the S&P 500, with a suggestion that you fill in your inputs and come up with your own estimate of value.
Some of you did take me up on my offer, came up with inputs, and entered them into a shared Google
spreadsheet and, in your collective wisdom, the market was overvalued by about 3.34% in mid-February.
While making assumptions about risk premiums, earnings growth and the treasury bond rate, I should have
emphasized the importance of narrative, i.e., the macro and market story that lay behind your numbers,
since without it, you can make assumptions that are internally inconsistent. To illustrate, here are two
inconsistent story lines that I have seen in the last few weeks, from opposite sides of the spectrum (bearish
and bullish).

 In the bearish version, which I call the Interest Rate Apocalypse, all of the inputs (earnings growth
for the next five years and beyond, equity risk premiums) into value are held constant, while raising the
treasury bond rate to 4% or 4.5%. Not surprisingly, the effect on value is calamitous, with the value dropping
about 20%. While that may alarm you, it is unclear how the analysts who tell this story explain why the
forces that push interest rates upwards have no effect on earnings growth, in the next 5 years or beyond,
oron equity risk premiums.
 In the bullish version, which I will term the Real Growth Fantasy, all of the inputs into value are left
untouched, while higher growth in the US economy causes earnings growth rates to pop up. The effect
again is unsurprising, with value increasing proportionately.
While neither of these narratives is fully worked through, there are three separate narratives about the
market that are all internally consistent, that can lead to very different judgments on value.
 More of the same: In this narrative, you can argue that, as has been so often the case in the last
decade, the breakout in the US economy will be short lived and that we will revert back the low growth, low
inflation environment that developed economies have been mired in since 2008. In this story, the treasury
bond rate will stay low (2.5%), earnings growth will revert back to the low levels of the last decade (3.03%)
after the one-time boost from lower taxes fades, and equity risk premiums will stay at post-2008 levels
(5.5%). The index value that you obtain is about 2250, about 16.4% below March 2nd levels.

The Return of Inflation: In this story line, inflation returns, though how the story plays out will depend upon
how much inflation you foresee. That higher inflation rate will translate into higher earnings growth, though
the effect will vary across companies, depending upon their pricing power, but it will also cause T. Bond
rates to rise. If the inflation rate in the story is a high one (3% or higher), the equity risk premium may also
rise, if history is any guide. With an inflation rate of 3% and an equity risk premium of 6%, the index value
that you obtain is about 2133, about 20.7% below March 2nd levels.

The Growth Engine Revs Up: In this telling, it is real growth in the US economy that surges, creating tailwinds
for growth in the rest of the world. That higher real growth rate, while pushing up earnings growth for US
companies (to 8% for the near term), will also increase treasury bond rates (to 3.5%), as in the inflation
story, but unlike it, equity risk premiums will drift back to pre-2008 levels (closer to 4.5%). The index value
that you obtain is about 3031, about 12.7% above March 2nd levels.

 A Melded Version: I believe in a melded version of these stories, where inflation returns (but stays
around 2%) and real growth in the economy increases, but only moderately. That will translate into higher
treasury bond rates (my guess would be 3.5%), with a proportionate increase in earnings growth (at least
in steady state) and an equity risk premium of 5%, splitting the difference between pre-crisis and post-crisis
periods. The index value that I obtain, with these assumptions, is about 2610, about 3.1% below March 2nd
levels.

You can see, even from this limited list of scenarios, that to assess how stock prices will move, as interest
rates change, you have to also make a judgment on why interest rates are moving. An inflation-driven
increase in interest rates is net negative for stocks, but a real-growth driven increase in interest rates is a
net positive. In fact, the scenario where interest rates go down sees a much bigger drop in value than two
of three scenarios, where interest rates rise.

The Bottom Line

When macro economic fundamentals change, markets take time to adjust, translating into market volatility.
During these adjustment periods, you will hear a great deal of market punditry and much of it will be half
baked, with the advisor or analyst focusing on one piece of the valuation puzzle and holding all else constant.
Thus, you will read predictions about how much the market will drop if treasury bond rates rise to 4.5% or
how much it will rise if earnings growth is 10%. I hope that this post has given you tools that you can use to
fill in the rest of the story, since it is possible that stocks could actually go up, even if rates go up to 4.5%, if
that rate rise is precipitated by a strong economy, and that stocks could be hurt with 10% earnings growth,
if that growth comes mostly from high inflation. I also hope that, after you have listened to the narratives
offered by others, for what markets will or will not do, that you start developing your own narrative for the
market, as the basis for your investment decisions. You've seen my narrative, but I will leave the feedback
loop open, as fresh data on inflation and growth comes in, and I plan to revisit my narrative, tweaking,
adjusting or even abandoning it, if the data leads me to.

Step 3: Review your investment philosophy

I firmly believe that to be a successful investor, you need a core investment philosophy, a set of beliefs of
not just how markets work but who you are as a person, and you need to stay true to that philosophy. It is
the one common ingredient that you see across successful investors, whether they succeed as pure traders,
growth investors or value investors. The best way that I can think of presenting the different choices you
have on investment philosophies is by using my value/price contrast:

To the question of which of these is the best philosophy, my answer is that there while there is one
philosophy that is best for you, there is no one philosophy that is best for all investors. The key to finding
that "best" philosophy is to find what makes you tick, as an individual and an investor, not what makes
Warren Buffett successful.

I see myself as an investor, not a trader, and that given my tool kit and personality, what works for me is to
be a investor grounded in value, though my use of a more expansive definition of value than old-time value
investors, allows me to buy both growth stocks and value stocks. I am not a market timer for two reasons.

 First, the overall market has too many variables feeding into it that I do not control and cannot
forecast, making my valuations inherently too noisy to be useful.
 Second, I see little that I bring to the overall market in terms of tools or information that will give me
an edge over others.
The truest test of whether you have a solid investment philosophy is a week like the last one, where you will
be tempted to or panicked into abandoning everything that you believe about markets. I would lying if I said
that I have not been tempted in the last week to time markets, either because of fear (driving me to sell) or
hubris (where I want to play market contrarian), but so far, I have been able to hold out.

Step 4: Act consistently

During every market crisis, you will be tempted to look and ask that ever present question of "What if?",
where you think about all of the money you could have saved, if only you had sold last Thursday. Not only
is this pointless, unless you have mastered time travel, but it can be damaging to your future returns, as
your regrets about past actions taken and not taken play out in new actions that you take. My suggestion
is that you return to your core investment philosophy and start to think about the actions that you can take
on Monday, when the market opens, that would be consistent with that philosophy. I am taking my own
suggestion to heart and have started revisiting the list of companies that I would love to invest in (like
Amazon, Netflix and Tesla), but have been priced out of my reach, in the hope that the correction will put
some of them into play. More painfully, I have been revaluing every single company in my existing portfolio,
with the intent of shedding those that are now over valued, even if they have done well for me. If nothing
else, this will keep me busy and perhaps stop me from being caught up in the market frenzy!

Spreadsheets

1. S&P 500 Intrinsic Value Spreadsheet

2. Google Shared Spreadsheet of Intrinsic Valuations

January 2018 Data Update 10: The Price is Right!

In my first nine posts on my data update for 2018, I focused on the costs that companies face in raising
equity and debt, and their investment, financing and dividend decisions. In assessing those decisions,
though, I looked at their actions through the lens of value creation, arguing that investing in projects that
earn less than their cost of capital is not a good use of shareholder capital. While this may seem like a
reasonable conclusion, it is built on the implicit assumption that financial markets reward value creation and
punish value destruction. As any market observer will tell you, markets have minds of their own, sometimes
rewarding companies for bad behavior and punishing companies that take the right actions. In this post, I
look at market pricing around the world, and point to potential inconsistencies with the fundamentals.

Value vs Price
In multiple posts on this blog, I have argued that we need to stop using the words, value and price,
interchangeably, that they not only can be very different for the same asset, at any point in time, but that
they are driven by different forces, require different mindsets to understand, and give rise to different
investment philosophies. The picture below summarizes the key distinctions:

Understanding the difference between value and price, at least for me, is freeing, because it not only makes
me aware of the assumptions that I, as an investor who believes in value and convergence, am making, but
also makes me respect and recognize those who might have a different perspective. The bottom line,
though, is that the pricing process can sometimes reward firms that take actions that no tonly have no effect
on value, but may actually destroy value, and punish firms that are following financial first principles. Even
though I believe that value ultimately prevails, it behooves to me to try to understand how the market is
pricing stocks, since it will help me be a better investor.

The Pricing Process

I will begin with what sounds like a over-the-top assertion. Much of what we see foisted on us as valuation,
including those that you see backing up IPOs, acquisitions or big investment decisions, are really pricing
models, masquerading as valuations. In many cases, bankers and analysts use the front of estimating cash
flows for a discounted cashflow valuation, while slipping in a multiple to estimate the biggest cash flow (the
terminal value) in what I call Trojan Horse DCFs. I am not surprised that pricing is the name of the game in
banks and equity research, but I am puzzled at why so much time is wasted on the DCF misdirection play.
There are four steps to pricing an asset or company well, and done well, there is no reason to be ashamed
of a pricing.

1. Similar, Traded Assets

To price an asset, you have to find "similar" assets that are traded in the market. Note the quote marks
around similar, because with publicly traded stocks, you will be required to make judgment calls on what
you view as similar. The conventional practice in pricing seems to be country and sector focused, where an
Indian food processing company is compared to other food processing companies in India, on the implicit
assumption that these are the most comparable companies. That practice, though, can not only lead to very
small samples in some countries, but also can yield companies that have very different fundamentals from
the company that you are valuing.
1.1: With equities, there are no perfect matches: If you are valuing a collectible (Tiffany lamp or baseball
card), you might be able to find identical assets that have been bought and sold recently. With stocks, there
are no identical stocks, since even with companies that are close matches, differences will persist.
1.2: Small, more similar, sample or large, more diverse, sample: Given that there are no stocks identical to
the one that you are trying to value in the market, you will be faced with two choices. One is to define
"similar" narrowly, looking for companies that are listed on the same market as yours, of similar size and
serving the same market. The other is to define "similar" more broadly, bringing in companies in other
markets and perhaps with different business models. The former will give you more focus and perhaps
fewer differences to worry about and the latter a much larger sample, with more tools to control for
differences.

2. Pricing Metric
To compare pricing across companies, you have to pick a pricing metric and broadly speaking, you have
three choices:
The market capitalization is the value of equity in a business, the enterprise value is the market value of the
operating assets of the firm and the firm value is the market value of the entire firm, including any cash and
non-operating assets. While firm value is lightly used, because non-operating assets and cash can skew it,
both enterprise value and equity value are both widely used. In computing these metrics, there are three
issues that do complicate measurement. One is that market capitalization (market value of equity) is
constantly updated, but debt and cash numbers come from the most recent balance sheets, creating a
timing mismatch. The second is that the market value of equity is easily observable for publicly traded
companies, but debt is often not traded (if bank debt) and book debt is used as a stand in for market debt.
Finally, non-operating assets often take the form of holdings in other companies, many of which are private,
and the values that you have for them are book values.
2.1: When leverage is different across companies, go with enterprise value: When comparing pricing across
companies, it is better to focus on enterprise value, when debt ratios vary widely across the companies,
because equity value at highly levered companies is much smaller and more volatile and cannot be easily
compared to equity value at lightly levered companies.
2.2: With financial service companies, stick with equity: As I have argued in my other posts, debt to a bank,
investment bank or insurance company is more raw material than source of capital and defining debt
becomes almost impossible to do at financial service firms. Rather than wrestle with his estimation problem,
my suggestion is that you stick with equity multiples.

3. Scaling Variable
When pricing assets that come in standardized units, you can compare prices directly, but that is never the
case with equities, for a simple reason. The number of shares that a company chooses to have will
determine the price per share, and arguing that Facebook is more expensive than Twitter because it trades
at a higher price per share makes no sense. It is to combat this that we scale prices to a common variable,
whether it be earnings, cash flows, book value, revenues or a driver of revenues (users, riders, subscribers
etc.).

3.1: Be internally consistent: If your pricing metric is an equity value, your scaling variable has to be an
equity value (net income, book value of equity). If your pricing metric is enterprise value, your scaling
variable has to be an operating variable (revenues, EBITDA or book value of invested capital).
3.2: Life cycle matters: The multiple that you use to judge pricing will change, as a company moves through
the life cycle.

Early in the life cycle, the focus will be on potential market size or revenue drivers, since the company's own
revenues are small or non-existent and it is losing money. As it grows and matures, you will see a shift to
equity earnings first, since growth companies are mostly equity funded, and then to operating earnings and
EBITDA, as mature companies use debt, ending with a focus on book value as a proxy for liquidation value,
in decline.

4. Control for differences

As we noted, when discussing similar companies, no matter how carefully you pick comparable firms, there
will be differences that persist between the company that you are trying to value and the comparable firms.
The test of good pricing is whether you detect the variables that cause differences in pricing and how well
you control for the differences. In much of equity research, the preferred mode for dealing with these
differences is to spin them to justify whatever pre-conceptions you have about a stock.
4.1: Check the fundamentals: In intrinsic value, we argued that the value of a company is a function of its
cash flows, growth and risk. If you believe that the fundamentals ultimately prevail in markets, you should
tie the multiples you use to these fundamentals, and using algebra and a basic discounted cash flow model
will lead you to fundamentals drivers of any multiple.

4.2: Let the market tell you what matters: If you are a pure trader, who has little faith that the fundamentals
will prevail, you can can take a different path. You can look at other data, related to the companies that you
are pricing, and look for correlation. Put simply, you are trying to use the data to back out what variables
best explain differences in market pricing, and using those variables to price your company.
To illustrate the differences between the two approaches, take a look at my pricing of Severstal, where I
used fundamentals to conclude that it was under priced, and my pricing of Twitter, at the time of its IPO,
where I backed out the number of users as the key variable driving the market pricing of social media
companies and priced Twitter accordingly.

Pricing around the Globe

Assuming that you have had the patience to get to this part of the post, let's look at the pricing numbers at
the start of 2018, around the world, starting with earnings multiples (PE and EV/EBITDA), moving on to
book value multiples (Price to Book, EV to Invested Capital) and ending with revenue multiples (EV/Sales).

1. Earnings Multiples
Earnings multiples have the deepest roots in pricing, with the PE ratio still remaining the most used multiple
in the world. In the last two to three decades, there has been a decided shift towards enterprise value
multiples, with EV/EBITDA leading the way. While I am skeptical of EBITDA as a measure of accessible
cash flow, since it is before taxes and capital expenditures, I understand its pull, especially in aging
companies with significant depreciation charges. If you assume that depreciation will need to go back into
capital expenditures, there is an intermediate measure of pricing, EV to EBIT.

In the chart below, I look at the distribution of PE ratios globally, and report on the PE ratio distributions,
broken down region, at the start of 2018.

I know that it is dangerous to base investment judgments on simple comparisons of pricing multiples, but at
the start of 2018, the most expensive market in the world on a PE ratio basis, is China, followed by India,
and the cheapest market is Eastern Europe and Russia. If you would like to see the values for earnings
multiples, by country, please click at this link.

If you are more interested in operating earnings multiples, the chart below has the distribution of EV/EBIT
and EV/EBITDA multiples:

China again tops the scale, with the highest EV/EBITDA multiples, and Eastern Europe and Russia have
the lowest EV/EBITDA multiples. Earnings multiples also vary across sectors, with some of the variation
attributable to fundamentals (differences in growth, risk and cash flows) and some of it to misplacing. The
sectors that trade at the highest and lowest PE ratios are identified below:

You can download the full list of earnings multiples for all of the sectors, by clicking on this link.

2. Book Value Multiples

The delusion of fair value accounting is that balance sheets will one day provide better estimates of how
much a business in worth than markets, and while I believe that day will never come, even accountants are
entitled to their dreams. That said, there are investors who still put their faith in book value and compare
market prices to book value, either in equity terms or operating asset terms:

 Price to Book Equity = Market Value of Equity / Book Value of Equity

 EV to Invested Capital = (Market Value of Equity + Market value of Debt - Cash)/ (Book value of
equity + Book value of Debt - Cash)
In the table below, I report on price to book and enterprise value to invested capital ratios, by sub-region of
the world:
The most expensive sub-region of the world is India, on both a price to book and EV/Invested capital basis,
and the lowest priced stocks are again in Eastern Europe and Russia. If you would like to see book value
multiples, by country, click at this link. With book value multiples, the differences you observe across
sectors not only reflect differences in fundamentals and pricing errors, but also accounting inconsistencies
on how capital expenditures in non-manufacturing companies are dealt with, as opposed to manufacturing
firms. I tried to correct for these inconsistencies, by capitalizing R&D at all firms, but that correction goes
only part way and the most expensive and cheapest sectors, with my corrected book values, are listed
below:
You can download the book value multiple data, by sector, by clicking here.

3. Revenue Multiples
To the question of why investors and analysts look at multiples of revenues, my one word answer is
"desperation". When every other number in your income statement is negative, you have to keep climbing
the statement until you hit a positive value. That said, there is value in focusing on a variable that
accountants have the least influence over, and the heat map below captures differences in the enterprise
value to sales ratios across the globe.

Unlike earnings and book value multiples, which have a pronounced peak in the middle of the distribution,
revenue multiples are more evenly distributed, with quite a few firms trading at more than ten times
revenues. As with earnings and book value multiples, I report revenue multiples, by country at this
link and by sector at this link. Note that there no revenue multiples reported for financial service firms, where
neither enterprise value nor revenues can be meaningfully measured or estimated.

Conclusion
I am an investor, who believes in value, but it would be foolhardy on my part to ignore the pricing game,
since I am dependent upon it ultimately to cash out on my value gains. In this post, I have looked at the
pricing differences around the globe, at least based upon market prices at the start of 2018. Of all of my
data posts, this is the one that is the most dynamic and likely to change over short periods, since markets
can react to change far more quickly than companies can.

YouTube Video

Datasets
1. Multiples, by Sector, in January 2018
2. Multiples, by Country, in January 2018

Data Update Posts

1. January 2018 Data Update 1: Numbers don't lie, or do they?
2. January 2018 Data Update 2: The Buoyancy of US Equities!
3. January 2018 Data Update 3: Taxing Questions on Value
4. January 2018 Data Update 4: The Currency Conundrum
5. January 2018 Data Update 5: Country Risk Update
6. January 2018 Data Update 6: A Cost of Capital Primer
7. January 2018 Data Update 7: Growth and Value - Investment Returns
8. January 2018 Data Update 8: Debt and Taxes
9. January 2018 Data Update 9: Dividends, Buybacks and Cash Holdings
10. January 2018 Data Update 10: The Price is Right!
Sunday, February 4, 2018
January 2018 Data Update 9: Dividends, Stock Buybacks and
Cash Holdings
If success for a farmer is measured by his or her harvest, success in a business, from an investors'
standpoint, should be measured by its capacity to return cash flows for its owners. That is not belittling the
intermediate steps needed to get there, since to be able to generate these cash flows, businesses have to
find ways to treat employees well, satisfy customers and leave society at ease with their existence, but the
end game does not change. That is why I find it surprising that when companies pay dividends, or worse
still, buy back stock, there are so many who seem to view them as failures. Perhaps, that flows from the
misguided view that reinvesting cash is good, not just for the company but also for the economy, because
it creates growth and returning cash is bad, because it is somehow wasted, both flawed arguments. A
company that reinvests cash in a bad business is destroying value, not adding to it, and as we saw in my
post on excess returns, a preponderance of companies globally earn less than their costs of capital. Cash
that is returned is not lost to the economy, but much of it is reinvested back into other businesses that often
have much better investment opportunities. That said, the way companies determine how much to return to
shareholders, either as dividends or in the form of buybacks, is grounded in inertia and me-tooism.

Dividends' Place in the Big Picture

In my corporate finance classes, I present what I term the big picture of corporate finance and the first
principles that should govern how a business is run:

If you view dividends as residual cash flows, which is what they should be, the sequence that leads to
dividends is simple. Every business should start by looking at its investment opportunities first, then finding
a financing mix that minimizes its hurdle rate and then based upon its investment and financing choices,
determine how much to pay out as dividends.

Note that this sequence holds only if capital markets (debt and equity) remain open, accessible and fairly
priced, and companies have no self imposed constraints on raising capital or dividend payments. Those are
clearly big and perhaps unrealistic assumptions for most companies, especially so for small firms and
companies in emerging market, and that is why I have titled it Dividend Utopia. In the real world, there are
multiple constraints, some external and some internal, that change the sequence.
1. Capital markets are not always open and accessible: In utopian corporate finance, a
company with a good investment opportunity, i.e., one that earns more than the cost of capital can
always raise capital from equity or debt market, quickly, at a fair price and with little or no issuance
costs. In the real world, capital markets are not that accommodating. Raising capital can be a costly
exercise, investors may under price your debt and equity, and the process can take time. It should
come as no surprise then that if a company pays too much in dividends in this setting, it will find
itself rejecting good investments.
2. Banks may be the only lending option: For many companies, the only option when it comes
to borrowing money is to go to a bank, and to the extent that banks face their own constraints on
lending, companies may be unable to borrow at what they perceive to be fair rates. This will
effectively play out in both investing and financing decisions.
3. Dividends are sticky: If there is one word that characterizes dividend policy around the
world, it is that it is "sticky". Companies, once committed to paying dividends, are unwilling to either
cut or stop paying dividends, for fear of market punishment. That stickiness translates into
companies continuing to pay dividends, even as earnings collapse and/or investment opportunities
expand.
In a world with these constraints, dividends are no longer a residual cash flow, determined by choices you
make on investments and financing, but a determinative cash flow, driving investment and financing
decisions. If you add the desire of companies to pay dividends similar to those that they have in the past
(inertia) and to be like the rest of the sector (me-too-ism) and irrational fears of dilution and debt, you have
the makings of dysfunctional dividends.
 In this circular universe, by putting dividend and financing decisions first, companies can end up with too
much or too little capital available for projects, and in this dysfunctional universe, they adjust discount rates
to make investment demand equate to supply. I never cease to be surprised by companies that claim to use
hurdle rates as high as 20% and as low as 3%, both numbers that are out of the range of any reasonable
cost of capital computation. In extreme cases, you can have dividend insanity, where companies that are
losing money and are already over levered borrow even more money to pay dividends, making their cash
flow deficits worse, leading to more losses, more debt and more dividends.

Dividends across the Life Cycle

If dividends are, in fact, a residual cash flow, estimating how much you can afford to pay is a simple exercise
of starting with the cash flows from operations that equity investors generate and netting out investment
cash flows and cash flows to and from debt.

In effect, everything you need to estimate this potential dividend or free cash flow to equity (FCFE) should
be in the statement of cash flows for a firm. This measure of potential dividends can be utilized, with my
corporate life cycle framework, to frame how dividend policy should evolve over a company's life, if it were
truly residual.

Note that the FCFE is the cash that is available for return and that companies can choose to return that
cash as traditional dividends or in buybacks. If they choose not to do so, the cash will accumulate as a cash
balance at the company.

The Compressed Life Cycle and Consequences

In this post from a while back, I argued that as we have shifted from the smoke stack and manufacturing
sectors of the last century to the technology and service companies of the modern era, life cycles have
compressed, creating challenges for both managers and investors.

That compressed life cycle has consequences for both how much companies can return to shareholders
and in what form:
1. Once mature, companies will return more cash over shorter periods: The intensity of both
the growth and the decline phases, with compressed life cycles, will mean that companies will
become larger much more quickly than they used to, both in terms of revenues and earnings, but
once they hit the "growth wall", they will find investment opportunities shrinking much faster, thus
allowing for more cash to be returned over shorter time periods.
2. Those cash returns will be more likely to be in buybacks or special dividends, not regular
dividends: The sweet spot for conventional dividends is the mature phase, where companies get to
enjoy their dominance and rest on their competitive advantages, with large and predictable
earnings. With the life cycle shortening and becoming more intense, this sweet spot period has
become much briefer. Think of how little time Yahoo! and Blackberry got to enjoy being mature
companies, before decline kicked in. Even the rare tech companies, like Microsoft and Apple, that
have managed to extend their mature phases have to reinvent themselves to keep generating their
earnings, making these earnings more uncertain. Paying large regular dividends in this setting is
foolhardy, since investors expect you to keep paying them, in good times and bad.
3. Companies that fight aging will see bigger cash build ups: No company likes to age, and it
should not come as a surprise that many tech companies fight the turn in their life cycles, deluding
themselves into believing that a rebirth is around the corner and not returning cash., even as free
cash flows to equity turn positive. At these companies, cash balances quickly balloon, attracting
activist investors.
In short, much of what managers and investors know or expect to see in dividend policy reflects a different
age and time. It should come as no surprise that older investors, especially ones that grew up with Graham
and Dodd as their investing bible find this new world bewildering. I can offer little consolation, since
globalization and disruption will only make things more unstable and less suited to paying large, stable
dividends.
Cash Return Numbers
Having laid the foundations for understanding the shifts that are occurring in dividend policy, we have a
structure for putting the numbers that we will see in this section in perspective. I will start this section by
looking at regular dividends and conventional measures of these dividends (dividend yield and payout ratios)
but then expand cash return to include stock buybacks and how metrics that capture its magnitude and
close by looking at cash balances at companies.

Regular Dividends
There are two widely used measures of dividends paid. One is to scale the dividends to the earnings,
resulting in a payout ratio. That number, to the extent that you trust accounting income and dividends are
the only way of returning cash to stockholders plays a dual role, telling cash-hungry investors how much the
company will pay out to them, and growth-seeking investors how much is being put back into the business,
to generate future growth (with a retention ratio = 1 - payout ratio). The picture below captures the distribution
of payout ratios across the globe, with regional sub-group numbers embedded in a table in the picture:

Note that the payout ratio cannot be computed for companies that pay dividends, while losing money, and
that it can be greater than 100% for companies that pay out more than their earnings. Japan has the lowest
dividend payout ratio, across regions, a surprise given the lack of growth in the Japanese economy., and
Australian companies pay out the higher percentage of their earnings in dividends.

The other measure of dividends paid is the dividend yield, obtained by dividing dividends by the market
capitalization. This captures the dividend component of expected return on equities, with the balance coming
from expected price appreciation. To the extent that dividends are sticky and thus more likely to continue
over time, stocks with higher dividend yields have been viewed as safer investments by old time value
investors. The picture below has the distribution of dividend yields for global companies at the start of 2018,
with regional sub-group numbers embedded:

As with the payout distribution, there are outliers, with companies that deliver dividends yields in the double
digits. While these companies may attract your attention, if you are fixated on dividends, these are
companies that are almost certainly paying far more dividends that they can afford, and it is only a question
of when they will cut dividends, not whether. With both measures of dividends, there is a hidden statistic
that needs to be emphasized. While these charts look at aggregate dividends paid by companies and
present a picture of dividend plenty, the majority of companies in both the US (75.8%) and globally (57.6%)
pay no dividends. The median company in the US and globally pays no dividends.

Buybacks
There is a great deal of disinformation out there about stock buybacks and I tried to deal with them in this
post from a couple of years ago. The reality is that stock buybacks have largely replaced dividends as the
primary mechanism for returning cash to stock holders, at US companies. In 2017, buybacks represented
53.69% of all cash returned by US companies, but the shift to stock buybacks is starting to spread to other
parts of the globe, as can be seen in the regional breakdown below:
While US companies still return more cash in the form of buybacks than their global counterparts, European
and Canadian companies also return approximately 38% of cash returned in buybacks, and even Indian
companies are catching on (with about 24% returned in buybacks). If you are interested in how much cash
companies in different countries return, and in what form, you can check this list, or the heat map below
(you can see the dividend yield and payout ratios, by country, in the live version of the map):

There are differences in how companies return cash, across sectors, and the table below lists the ten
sectors that return the most and the least cash, in the form on buybacks, as a percent of cash returned.

Commodity companies and utilities are still more likely to return cash in the form of dividends, while software
and technology companies are more likely to use buybacks. If you are interested, you can download the
entire sector list, with dividends, buybacks and associated statistics.
Cash Balance
There is one final loose end to tie up on dividends. If companies don't return their FCFE (potential
dividends) to stockholders, it accumulates as a cash balance. One way to measure whether companies
are returning enough cash is to look at cash balances, scaled to either the market values of these firms or
market capitalization. The table below provides the regional statistics on cash balances:

Japan is clearly the outlier, with cash representing about 34% of firm value, and an astonishing 68% of
market capitalization. It may be a casual empiricism, but it seems to me that Japan is filled with walking
dead companies, aging companies whose business models have crumbled but are holding on to cash in
desperate hope of reincarnation. It is the Japanese economy that is paying the price for this recalcitrance,
as capital stays tied up in bad businesses and does not find it way to younger, more vibrant businesses.

Conclusion
If the end game in business, for investors, is the generation and distribution of cash flows to them, many
companies and investors seem to be stuck in the past, where long corporate life cycles and stable earnings
allowed companies to pay large, steady and sustained dividends. Facing shorter life cycles, global
competition and more unpredictable earnings, it should come as no surprise that companies are looking for
more flexible ways of returning cash, than paying dividends and that buybacks have emerged as an
alternative. As companies take advantage of the new tax law and bring back trapped cash, some will
undoubtedly use the cash to buy back stock, and be loudly declaimed by the usual suspects, for not putting
the cash to "productive" uses. I would offer two counters, the first being my post on excess returns where I
note that more than 60% of global companies destroy value as they try to reinvest and growth, and the
second being that it is better for economies, for aging companies to give cash back to stock holders, to
invest in better businesses.

January 2018 Data Update 8: Debt and Taxes

In the United States, as in much of the rest of the world, and as has been true for most of the last century,
the tax code has been tilted towards debt, rewarding firms that borrow money with tax savings, relative to
those that use equity to fund their operations. While the original rationale for this debt bias was to allow the
large infrastructure companies of the equity markets (railroads, followed by phone and natural resource
companies) to raise financing to fund their growth, that reason has long dissipated, but a significant segment
of the economy is built on debt. The most revolutionary component of the US tax reform package that
passed at the end of last year is that it reduces the benefits of debt in multiple ways, and by doing so,
challenges companies that have long depended on debt to reexamine their financing policies.

The Trade Off on Debt and the Tax Reform Package

In last year’s update on debt, I summarized the trade off on debt, listing both the real pluses and minuses
of debt as well as what I called the illusory benefits. In the latter group, I included reasons like debt is cheaper
than equity and dilution benefits:
The bottom line is that it is the tax advantage of debt that makes it attractive to equity, and the benefits to
borrowing were greater in the United States than in any other country last year, for a simple reason. The
US had the highest marginal corporate tax rate in the world, at 40%, and companies that borrowed
effectively claimed their tax benefits at that rate. To the oft touted counter that no US companies pay 40%,
that is true, but it actually makes the tax benefit of debt even more perverse. Companies in the United States
have been able to pay effective tax rates well below 40%, while maximizing their tax benefits from debt. As
an example, consider Apple, which paid an effective tax rate of less than 25% on its global income last year,
partly because it left so much of its foreign income off shore (as trapped cash). Apple still managed to borrow
almost $110 billion in the United States, and claim the interest expenses on that debt as a tax deduction
against its highest taxed income (its US income). For those of you who find this unethical, please spare me
the moralizing since your disdain should be directed at those who wrote the tax code.

As I noted in my post on the changes that tax reform is bringing, the biggest are going to be to the tax
benefits of debt, which will be dramatically decreased starting this year, for two reasons:
 1. Lower marginal tax rate: The marginal tax rate for the United States has gone from being
the highest in the world to close to the middle. At a 24% marginal tax rate, which is where I think
we will end up with state and local taxes added to the new federal tax rate of 21%, you are effectively
reducing the tax benefit of debt by about 40% (from 40% to 24%). In the heat map below, I have
highlighted marginal tax rates of countries, with a highlighting in shades of rec of those that will have
lower marginal tax rates than the US after 2018. To provide a contrast, this picture would have been
entirely in shades of red last year, before the tax rate change, since there was no other country with
a corporate tax higher than 40%.
1. Limits on interest tax deductions: Until last year, as has been the case for much of the last
century, US companies have been able to claim their interest expenses as tax deductions, as long
as they have the income to cover these expenses. With the new tax code, there is a limit to how
much interest you can deduct, at 30% of adjusted taxable income. Any excess interest expenses
that cannot be deducted can be carried forward and claimed in future years, and that provision will
help companies with volatile earnings, since they will be able to claim back deductions lost in a bad
year, in good years. As is its wont, Congress has chosen to make up its own definitions of adjusted
taxable income, with EBITDA standing on for operating income until 2021 and then transitioning to
earnings before interest and taxes (EBIT).
There are two other provisions in the tax code which will also indirectly affect the debt trade off.
1. Capital Expensing: Attempting to encourage investments in physical assets, especially at
manufacturing companies, the tax code will allow companies to expense their capital investments
for a temporary period. The resulting tax deductions may be large enough to reduce the benefit to
having the interest tax deduction. That effect will be magnified by the fact that the companies that
are most likely to be using the capital expensing provisions are also the companies that have used
debt the most in funding their operations.
2. Un-trapped Cash: As companies are allowed to pay a one-time tax and bring trapped cash
back to the United States, the cash will be now available for other uses and reduce the need for
debt as a funding source. Note that estimates of this trapped cash, collectively held by US
companies, exceed $3 trillion and that even if only half of this cash is brought back, it would still be
a substantial amount.
All in all, there are multiple provisions in the tax code that handicap the use of debt and very few, perhaps
even none, that would make debt a more attractive source of financing.

Optimal Capital Structure

To quantify the impact of the tax code’s change on how much debt a company should have and how much
value it adds, I used an old but flexible optimizing tool: the cost of capital. It is, of course, the number around
which a post looking at how it varies around the world and sectors. In the follow up post, I used the cost of
capital as a hurdle rate to judge the quality of a company’s investments. In this one, I will use it to talk about
the right mix of debt and equity, and how it affects value:

Note that as you borrow more money, your costs of equity and debt go into motion, increasing as the debt
increases and the trade off from the last section plays out, with the tax benefits showing up as an after-tax
cost of debt and the bankruptcy costs partially captured in the higher costs of both equity and debt and
partially as drops in operating income. Note that the key changes in the 2017 tax reform package, at least
as they relate to the trade off, are highlighted. I used Disney as an illustrative example, and computed the
costs of capital at every debt ratio under the old tax regime and the new one and the results are in the
graph below:

The cost of capital is a driver of the value of the operating assets, and since the costs of capital are higher
at every debt ratio than they used to be, it should come as no surprise that the value added by debt has
dropped at every debt ratio, with the new tax code.

The easiest way to see the effects of the new tax code are to look at how it plays out in the cost of capital
and values of real companies. I will use Facebook, Disney and Ford as my examples, partly because they
are all high profile and partly because they have widely divergent current debt policies, with Facebook having
almost no debt, Disney a moderate amount and Ford more debt. With each firm, I computed the schedule
of cost of capital, holding all else constant (both micro variables like EBIT and EBITDA and macro variables
like the risk free rate and ERP.), with the old and new tax codes. I do this, not because I believe that these
numbers will not be affected by the tax code, but because I want to isolate its impact on debt.
For all three firms, the effect of the new tax code is unambiguous. The value added by debt drops with the
new tax code and the change is larger at higher debt ratios. Taking away 40% of the tax benefits of debt
(by lowering the marginal tax rate from 40% to 24%) has consequences. Note, though, that the lost value is
almost entirely hypothetical, for Facebook, since it did not borrow money even under the old code and did
not have much capacity to add value from debt in the first place. It is large, for Disney and Ford, as existing
debt becomes less valuable, with the new tax reform. Note, though, that both companies will also benefit
from the tax code changes, paying lower taxes on income both domestically, with the lowering of the US tax
rate, and on foreign income, from the shift to a regional tax model. Ford, in particular, could also benefit
from the capital expensing provision. My guess is that both firms will see a net increase in value, with all
changes incorporated. With these three firms, at least, the cap on the interest expense deduction (set at
30% of EBITDA for the near term) does not affect value at their existing debt ratios and is not a binding
constraint until they get to very high debt ratios.

Debt Ratios- Cross Sectional Distributions

If you accept my reasoning that the new tax code will lower the value of debt in capital structure, and that
the effect will be most visible at firms that borrowed a lot of money under the old tax regime, the only way
to assess the tax code’s impact is to look how debt ratios vary across companies, and what type of firms
and in what sectors borrow the most.

To get a measure of what comprises a high debt ratio, I started by looking at the distribution of debt ratios
across companies, for both US and global companies:

I was surprised by how many firms in the global sample have little or no debit their capital structure, with
more than half of all firms in the sample having total debt to capital ratios of less than 10%. In fact, netting
cash out from debt would lead to even lower net debt ratios. That said, there is enough debt at the largest
firms that the aggregated debt ratios across all firms is significantly higher. Looking at these aggregated
debt ratios, you would expect US companies to have been borrowing more money than companies in
other parts of the world, and to see if they did, I looked at measures of financial leverage, from debt scaled
to capital to debt to EBITDA globally:

The results are mixed. While US companies look like they are the most highly levered in the world, if you
scale debt (gross and net) to book value, US companies don’t look like outliers on any of the dimensions.
In fact, the only real outliers seem to be East European companies that borrow far less than the rest of the
world, relative to EBITDA, and Indian companies, that borrow less, relative to market value. Looking
across sectors, you do see clear differences, with some sectors almost completely unburdened with debt
and others less so. While you can get the entire list from clicking on this link, the most highly levered
sectors in the US are highlight below, relative to both market capital and EBITDA.

I removed financial service firms from this list, since debt to them is a raw material, not a source of capital,
and real estate investment trusts, since they do not pay corporate taxes, under the old and new tax regimes.
As I noted in my post on tax reform, it is the most highly levered sectors that will be exposed to loss of value
and it is entirely possible that the net effect of the tax change can be negative for them.

Implications
You seldom get to observe a real world experiment of the magnitude that we will be faced with in 2018, with
the tax code in change and the loss in value added from debt. Given the changes, I would expect the
following:
1. Deleveraging at firms that have pushed to their optimal debt ratios, under old tax code:
While there are many firms, like Facebook. where debt was never a source of added value, where
the tax code will affect that component of value very little, there will be other highly levered firms
where the value change will be substantial. In fact, many of these firms, which would have been at
the right mix of debt and equity, under the old tax regime, will find themselves over levered and in
 need of paying down debt. Given that inertia is the primary force in corporate finance, it may them
a while to come to this realization.
2. Go slow at firms that have held back: For firms like Facebook that have held back from
borrowing, under the old tax code, the new tax code reduces the incentive to add to debt, even as
they mature. As you can see from the numbers on Facebook, Disney and Ford, the benefits of debt
have been significantly scaled down.
3. Transactions that derive most of their value from leverage will be handicapped: Since the
mid-1980s, leveraged transactions have been favored by many private equity investors. While one
reason was that they were equity constrained (and that reason remains), the bigger reason was
that it allowed them to generate added value from recapitalization. At the risk of over generalizing,
I will argue that for a large segment of private equity investors, this was the primary source of their
value added and for these investors, the new tax code is unequivocally bad news, and I will shed
no tears for them.
As I noted at the start of this post, debt is part of the fabric of business in the United States, and there are
some businesses and asset classes that have been built on debt. Real estate and infrastructure businesses
have historically not only used debt as a primary source of funding but as a value addition, with the added
value coming from the tax code. Now that the added value is much lower, it remains to be seen whether
asset values will have to adjust.
Conclusion
From financial first principles, there is nothing inherently good or bad about debt. It is a source of financing
that you can use to build a business, but by itself, it neither adds nor detracts from the value of the business.
It is the addition of tax benefits and bankruptcy costs that makes the use of debt a trade off between its
benefits (primarily tax driven) and its costs (from increased distress and agency costs). The new tax code
has not removed the tax benefits of debt but it has substantially reduced them, and we should expect to see
less debt overall at companies, as a consequence. In my view, that is a positive for the economy, since debt
magnifies economic shocks to businesses and not only creates more volatile earnings and value, but
deadweight costs for society.