What betas can... and cannot do...

There is no concept that is more abused, and more misinterpreted, than beta in corporate finance. I have heard betas blamed for everything from global warming to the market collapse. "Warren Buffet does not use beta", the refrain goes, "so why should I?"

I think the biggest mistake that people make is to wrap betas up with the assumptions of the capital asset pricing model (CAPM). Does the CAPM make unrealistic assumptions about no transactions costs and no private information to get to its final conclusion (that all exposure to market risk can be captured in a beta, which should then be the sole determinant of the differences in expected returns)? Absolutely. However, just because you don't like the CAPM's rigidity does not mean that you throw the baby out with the bathwater and abandon beta as a measure of risk, or worse, use no measure of risk at all.

I think of betas as measures of relative risk, with the risk defined as exposure to macro economic variables (interest rates, overall economic growth, inflation). Thus, a stock with a beta of 1.2 is 1.2 times more exposed to macro economic risk than the average stock in the market. That proposition stands, whether one buys into the CAPM or not. Seen from that perspective, here are the things betas cannot do:
1. Explain changes in returns for the entire market. The betas for all stocks cannot go up at the same time, since they have to average out to one. (This is in response to those who have argued that the recent drop in equity prices can be explained by an increase in betas across the board.)
2. Capture emerging market risk. If we regress the returns on emerging market stock against emerging market indices, which is the standard practice for most estimation services, the average beta for Indonesian stocks will be one, as will the average beta of Swiss stocks. If we run regressions against a global index, the results are often unpredictable, with betas for emerging market companies often dropping simply because they are such as a small part of the index.
3. Capture firm specific risk: Betas cannot incorporate risks that affect only a firm or a few firms, even if these risks are huge. Thus, a tobacco company's beta cannot reflect litigation risk and a biotech firm's beta will not capture the uncertainty inherent in the FDA approval process.

Here is what betas can do. They can capture shifts in risk across the market. If a sector gets riskier, its beta should go up, but there has be another sector whose risk has to go down to compensate. Thus, banks will have higher betas today than they did a year ago but technology firms may have seen their betas decline, as they have held up fairly well in this downturn. They provide simple, intuitive and surprisingly effective snapshots of how risky an investment is, relative to the rest of the market, especially if you are an investor with multiple investments in your portfolio.

I do have to mention in closing that running a regression of stock returns against a market index is both a terrible way of estimating betas and of thinking about betas. However, this post is already way too long for me to suggest alternatives to regression betas. That will come in the next post.

Executive Compensation Caps

The news of the day is the decision by the Obama administration to put caps on executive pay, at least at the companies that have lined up to received funds from the government. Not surprisingly, there are people with strong views lining up on both sides of the issue. So, I guess I will stick my toe into the water and hope not to get burned (since there is an obvious political component to this debate).

As a general rule, I don't think governments should have any role to play in setting compensation limits. The heavy hand of government intervention will not only create quirks in the labor market but have unintended consequences. For instance, the US government (in its last populist phase in the early 1990s) decided that executives were getting too much and decided to restrict the compensation that firms could deduct for tax purposes to $ 1 million (per executive)... Since compensation was defined in the legislation as pay and bonuses, and did not include options, it played a role in triggering the huge option packages that executives have received in the last two decades.

But here is why I am torn. The proposed executive pay cap is toothless for most companies and will have an impact only at those firms that have used the federal government as a piggy bank (Citi and BofA ). If we accept the proposition that there is no free lunch, these firms asked taxpayers for capital, were provided this capital and are in no position to deny taxpayers a say in how they make decisions or compensate employees. (As taxpayers, we are singularly unfortunate that we are represented in this process by legislators who have the attention spans of infants and the time horizons of riverboat gamblers...) Faustian bargains have a way of coming back to haunt you.... You lie down with dogs, you wake up with fleas!! (No more analogies, I promise!!!!)

I must close by noting that I think executive compensation is way out of hand at many companies but I think that just as voters in a democracy get the government that they deserve, stockholders are getting the treatment that they too deserve. If we want compensation to be reasonable, and by reasonable, I am not ruling out very large compensation for managers who truly deserve it (Steve Jobs at Apple should be given a few hundred million), we should not be looking to the government for solutions but to ourselves. Investors, and especially institutional investors, need to work to put in place rules that give them more say in compensation. I also like the British notion of putting top management compensation agreements up for stockholder approval routinely.

Low riskfree rates...

One of the many perils of valuing a company in the US or Europe right now is that the riskfree rates in US dollars and Euros are at unprecedented lows - about 2.3% in US $ and about 2.8% in Euros. Analysts, confronted with these riskfree rates, are faced with a quandary. If they use the low riskfree rates, they end up with low discount rates which then result in high valuations. To get around this problem, many are asking the question: Are riskfree rates too low and should we replace them with higher normalized rates (perhaps average rates over time)? Good question, but the wrong place to ask it...

Let me take a step back. It is true that riskfree rates are low but they are not the only numbers at unusual levels. Equity risk premiums and default spreads are at historical highs and the worry about global economic growth is deeper than at time in recent history. When we use low riskfree rates in valuation, we have to accompany them with much higher risk premiums than we would have used a few months ago, lower real growth and lower expected inflation. The net effect is that intrinsic values are lower now than they were a few months ago. 

What gets analysts into trouble is inconsistency. If we use today's riskfree rates and stick with risk premiums that we used to use in the past and growth rates and inflation rates that are also from the past, we will over value companies. The culprit is not the low riskfree rates but internal inconsistency. 

My advice is that you stay with today's riskfree rates but update the other numbers you use in valuation to reflect the environment we face right now. If you insist on replacing today's riskfree rate with your normalized number, you should then adjust all your other numbers to be consistent - not easy to do, in my view. 

Finally, I have a paper on riskfree rates that you may find useful (or not). You can find it by clicking on this link.

I hope you find it useful.

Bias in Valuation

I kicked off the valuation class with a discourse (actually, more of a rant) about the bias in the valuation process and how it skews numbers. I firmly believe that bias is, by far, the biggest enemy of good valuations and that it is pervasive. By bias, I am referring not only to the preconceptions we bring into the valuation of a company but also to the payoff to doing the valuation. He who pays the prices sets the bias in motion, and the valuation reflects it. Thus, if I were an investment banker hired to value a target company in an acquisition, I am going to bias my value upwards, since I make money if the deal goes through but not if it does not. I am sure that Pfizer has an investment banking valuation of Wyeth, right now, that backs up their bid.  In class today, I set up 12 different valuation scenarios and asked for guesses on the direction of the bias. Here is the link to the list:

http://www.stern.nyu.edu/~adamodar/pdfiles/eqnotes/biastests.pdf

Make your best guesses... Visit my web site for the answers.

So, what is the cure for bias? I am afraid that there isn't one. However, we can reduce bias by changing the process by which we pay for valuations. 

1. No deal maker should ever be asked to analyze whether the deal makes sense. This is what we ask of investment bankers in acquisitions. The process will create bad valuations. I think that acquirers should pay a third party (one that makes money only for doing appraisals) for the valuation.

2. In legal processes, we should have less adversarial valuation, where the expert for one side comes in with a high number and the other side with the low number and the court splits the difference.

3. Trust, but verify. Even the biggest names in the business - Goldman, McKinsey - are susceptible to bias. 

As someone who looks at other peoples' valuations all the time, what experience has taught me is that the most critical questions to ask in assessing  a valuation are: Who paid the appraiser to do the valuation? What are the potential sources of bias? That tells me a great deal more than perusing the numbers.

Rebirths and Fresh starts!

As many of you know already, I view myself as a teacher first and everything else - academic, researcher, professor - second. There are many reasons why I love teaching but as I get ready for the first class of the Spring semester, here is one. I get to start with a completely fresh slate, with a new class and a new subject. Everything I have done before is irrelevant and any mistakes or accomplishments from the past are erased. That kind of new beginning is tough to find in any other profession. The closest you can get to it is when you get a new job at a company where you know no one.... But you cannot keep doing that every six months... as I get to...

My blogs over the next few months will reflect what I am talking about in my corporate finance and valuation classes. Obviously, I will not bore you with the details, but if you are so inclined, you should be able to peek in on the class, since the lectures are webcast. So, I am off to class! Even after 25 years of doing this, I am excited and I hope the excitement rubs off on those in the class.

Data update for January 2009

As those of you who are on my mailing list (now about 15000 long)  know, I just completed by annual update of data about a week ago. If you are unfamiliar with my data updates, you can get the data on my website:

http://www.stern.nyu.edu/~adamodar/New_Home_Page/data.html

I have been reporting industry averages for corporate finance and valuation variables (returns, betas, costs of capital multiples)  for a while now: this is my 15th annual update for US companies, and my seventh for European, Japanese and Emerging Market companies. In most years, the changes over the previous year have been marginal, especially for developed market companies. But the 2009 update was very different. Here are some of the highlights:

1. Risk premiums: Both the equity risk premium and default spreads on debt jumped dramatically over the year. The equity risk premium started 2008 at 4,37% and ended the year at 6.43%, its highest value since 1978. The default spreads more than doubled, and in some cases tripled, over the year for every single ratings class; for instance, the spread on a Baa1 rated bond increased from 1.75% to 5.25%. This will have profound effects on valuation. The same company, with earnings, beta and rating unchanged, but with default spreads updated is worth about 40% less today (in intrinsic value terms) than it was a year ago. (One aside. The risk premiums for debt increased more than the risk premiums for equity, which has implications for the mix of financing used by firms).

2. Emerging Market risk: In a crisis, risky asset classes get hit the worst and the country risk premiums for emerging markets have increased for two reasons. One is that the base mature market premium is now higher. The second is that the premium you demand for an emerging market is now higher. For example, the equity risk premium for India has increased from 7% to 11%. The drop in the Sensex should be no surprise.

3. On a multiple basis, everything looks cheap: The sector averages for every multiple - revenue multiples, PE ratios and EV/EBITDA - seem to suggest that we are surrounded by bargains. Before you jump in, a note of caution. The prices are as of January 2009 but accounting numbers lag. The most recent fiscal year for most companies in January 2009 is the 2007 fiscal year. Even trailing 12-month data ends in September. We are scaling post-crisis prices to pre-crisis accounting numbers. Hence, the low multiples. I will do an update in May 2009 and those numbers should contain some of the crisis impact. I am afraid the mismatch will not disappear until the 2010 update.

One final note. I have been asked why I do these data updates and put them on my site. I would love to claim that I am the "Mother Theresa" of finance but I do it for purely selfish reasons. Curiosity drives me to look at the data, and since the tools to convert raw data to accessible data are easily accessible, I bear no cost in sharing what I find with the rest of the world. I hope you find the data useful. 

Corporate Finance - post crisis

I just finished teaching my first corporate finance class in the post-crisis period (to an executive MBA class). Having taught this class for close to 25 years now, I was wondering how I would bring in the events of the last few months into the sessions and be able to draw out the implications for businesses. I must confess that it was a lot less trying than I thought it would be.

In broad terms, these are the corporate finance implications that I see for the near future and the long term:
a. In investment analysis: I see a shift away from expected value and base case valuations that have dominated financial analysis for the last few decades to more probabilistic approaches. Since both the data and the tools (Crystal Ball, @Risk etc.) are accessible and available now to most of us, I think this shift is long overdue.

b. In risk and hurdle rates: For the near term, I see a move towards higher risk premiums for both equity and debt, reflecting recent history and changes in risk aversion. In the long term, I think that we have to become more dynamic in our assesments of risk parameters and premiums, since the assumption that these numbers don't change much has clearly been shaken. Put another way, we have to accept the fact that risk premiums can change quickly even in developed markets and even more so in emerging markets.

c. In capital strucure: If debt represents a trade off between tax benefits on one side and expected bankruptcy costs on the other, the last few months have clearly tilted the scales away from the use of debt. The probability of distress and the cost of distress have both increased, particularly so for large companies where the notion that capital markets would provide needed funds is no longer universally accepted. I expect to see debt ratios decrease as companies retool and a less cavalier use of short term financing to fund long term assets.

d. In dividend policy: In the short term, companies will value liquidity and cash balances will go up. In the long term, the events of the last few months will make companies even more wary about instituting and increasing dividends (because of the instability and unpredictability of earnings) and I would not be surprised to see even more of a shift towards flexible cash return policies (stock buybacks).

I feel more confortable now, going into the new semester. I don't have all of the answers but I feel that I have a framework for approaching the questions. The 450 students in my class will put me to the test and I am looking forward to it. You will have a ring side seat.