A new semester begins: Valuation class online

If you are a teacher, you measure your life in quarters and semesters. This is my fiftieth semester teaching, and, as in each of the prior forty nine semesters, I could not wait to get started. Coddled as only tenured faculty at a research university can be, I have only one class to teach this semester. The class is "Valuation", and it is about valuing any asset: stocks, businesses, sports teams and collectibles are all fair game. While the class begins with an extended discussion of intrinsic (DCF) valuation , it will extend to cover multiples/comparables and real options. The first class was Wednesday, September 5, and I will teach it every Monday and Wednesday for the next 15 weeks (with a few days off in the middle) from 10.30 to 12 at the Stern School of Business at New York University.

At the start of this year, I argued that universities have used their "monopoly" status in the education business to protect themselves from needed change. I also presented my view that "disruptive" changes were coming, largely because technology has undermined the entrenched competitive advantages that have allowed universities to charge premium prices for often below-average products. I also put my class online, using a company called Coursekit, and a few thousand people enrolled in the class. While life got in the way of completing the class for some of these students, I was gratified by the feedback I got on the class and I did learn from some of my mistakes (though I undoubtedly will make more mistakes soon). Symbolizing how quickly this business is shifting, Coursekit has changed both its look and its name (it is now called Lore), raised more capital and is aiming for bigger and better things. I wish them well, but I have decided to broaden the choices available to those who would like to take my Valuation class this semester. So, if you are interested, here they are:

1. School website: I maintain a website at Stern for the class that includes everything that I do in this class: webcasts of the classes, lecture notes and quizzes/exams. You can find them all by clicking onn the link below:
http://www.stern.nyu.edu/~adamodar/New_Home_Page/webcasteqfall12.htm
The plus is that this is my first stop when I add or update anything to the class and it is the one place where you will be guaranteed to find everything to do with the class. The minus is that I am not a master at web design and the look and it shows: things are sometimes difficult to find and it is short on eye candy.

2. Lore: I will continue to teach this class on Lore, but rather than maintain two separate classes (as I did last semester), I will consolidate the class in one location. Since I will be using Lore to keep track of those who are registered and are taking the class at Stern, you will be auditing the class on Lore, if you choose this option. To join the "audtior" list, click below:
join.lore.com/c2d550c59a7f

Note that you will have all of the access to materials and webcasts of the registered students. For the moment, though, you will be able to read posts and comments but you cannot post: I will work on seeing whether I can change that, to allow you to participate in discussions. The plus is that the site is much more polished than mine will ever be, but the minus is that you have to work within the Lore structure, which may not be to your liking. 

3. Apple iTunes U: As a long time Apple user, I have watched the development of Apple iTunes U with interest. What started as a site with just class videos and no interaction is evolving into something more typical of Apple: beautiful and useful at the same time. The downside, though, is that you need an Apple device to use iTunes U, preferably an iPad. If you do have one, here is what you can do:

Step 1: Go to the Apple App store and download Apple iTunes U. Don't worry. It is free.
Step 2: On your Apple device, open your email and click on the link below

https://itunesu.itunes.apple.com/audit/COK8RVCXTC

Step 3: Apple iTunes U should open up and the class should be on your shelf.

Step 4: You may need to wait until I let you into the site. (I am working on making this a public course but there seem to be some barriers in place...)

The plus is that the site is dazzling in terms of beauty but the minus is that you cannot get to it on your Android or Blackberry device.

4. YouTube:  I am using a site call Symynd to provide access to the class resources to anyone who is interested in valuation. This site, which aims to democratize education, converts the webcasts into YouTube videos and provides access to the material. You can get to the site by going to:

http://www.symynd.com/courses/view/abfixK/

For those of you who have trouble downloading the large lecture webcast files (150 GB and higher) that are offered on the other channels, the YouTube videos work much better, since they are compact. There is a Facebook page for the class, where you can post and respond...

I hope that one of these four channels works for you and that you can come along for the ride. As always, I am interested in finding out not only what works, but what does not. The first session of the class was last Wednesday (September 5) and you have plenty of time to catch up before the next class on Monday. I will post the webcasts on all four channels about an hour after the class ends (between 1 pm and 2 pm, New York Time, every Monday and Wednesday).

Apple's Crown Jewel: Valuing the iPhone Franchise

If you are a stockholder in Apple, it is time to celebrate again! The last week has been an eventful one for the company. In addition to claiming the title of "largest market cap" ever, when its market value hit $623.5 billion on August 20, the company also won its lawsuit against Samsung on "patent infringement" charges. Samsung will not only be required to pay $ 1 billion in damages but may also have to remove some of it products from the US market as a consequence. To add to the mix, the iPhone 5 will shortly be arriving on the shelves and there is talk again of Apple becoming the first trillion dollar company ever.

As with my last two posts, I want to set the record straight on my posts on Apple in the last couple of years. In January 2011, I posted on Apple's immense cash balance (of $50-$60 billion at the time). and argued that, as a long-term investor in the company, it has earned my trust after an unmatched decade of success, both in terms of profitability and stock returns, and that I was okay with them holding on to the cash. In March 2012, I returned to the question partly in response to news stories that suggested that Apple may initiate a dividend. Noting that dividends would attract a very different group of stockholders into the company and put them on collision course with the existing stockholder base, I posted that if Apple was intent on returning the cash (as Tim Cook seemed to be), it should do a large stock buyback. I also valued the company at about $710/share (the stock price was about $550 at the time). In April 2012, the stock hit $600 and I bid my farewell to the company as an investment, with much regret and gratitude. I justified my decision to sell not on valuation (since I found the stock to be worth $700+) but on two counts. First, I argued that the company had become a momentum play and that the pricing process had lost its connection to the valuation process. Second, I also felt uncomfortable with the mix of dividend, growth and momentum stockholders, with differing expectations about the company and differing demands of it. Even though Apple’s stock price has gone up about 10% since I sold it, I have no regrets about selling. Since my original case for selling the shares was predicated on a fickle investor base with conflicting views, I believe that the stock price gyrations over the last six months supports that thesis. The stock price dropped as low as $530 and now risen to its high for the year without any dramatic news announcements for the most part driving the price (until the last week). My intrinsic valuation has not changed much in that period and remains over $700, with the updated numbers through the end of last quarter. 

No matter what your views (bullish or bearish) are on Apple, I think that there can be little disagreement on the proposition that Apple's market value rides more on one product, the iPhone than ever before and that it is worth taking a closer look at the underpinnings of that value. Looking at the numbers, here are three key points worth making about the iPhone franchise (and its value to Apple):

1. The iPhone is a money machine: In the most recent twelve months, the iPhone generated about $100 billion in revenues and approximately $21 billion in after-tax profits for Apple.
2. The iPhone is a dominant player in a growing market: The smartphone market grew about 40% last year,  primarily as cell phone users switch to smart phones. During the year,  more than 150 million smart phones were sold, with Apple accounting for about 20% of the units sold. However, with its heftier price tag on the iPhones, Apple had a 43% share of the market, if it is defined in dollar revenues. 
3. The iPhone has a short life cycle: One of the reasons for Apple's disappointing earnings in the most recent quarter is that customers stopped buying the iPhone 4S, waiting for the iPhone 5 to arrive. Since the iPhone 4 came out in June 2010 and the iPhone 4S was introduced in October 2011, that puts about a two-year life cycle on the product.  So what? Companies like P&G or Coca Cola produce products that have very long life cycles; diapers and sodas have not only not changed much over the last few decades but are unlikely to change by much over the next few. Protected by strong brand names, they can be expected to generate earnings for long periods, with relatively little investment or innovation by the companies in question. With a short product life cycle, a company is faced with two challenges. First, it has to come up with innovations to its product to retain its customers when the cycle is renewed, and that will require investment, especially during the later parts of each cycle. Second, even with these innovations, there will be customers who switch to competitors' products (either because they are cheaper or because their innovations are more attractive) and for a company to maintain it's market share, it has to get more of it's competitors' customers to switch to its products. 

Given the iPhone's profitability and dominance in the growing smartphone market, I tried to value the iPhone franchise, incorporating the effect of the short life cycle. In assessing the value, I made the following assumptions.

1. Profitability: Apple will be able to maintain its current after-tax operating margin of 21% on future iPhone sales. 
2. Smartphone market: The smart phone market will continue to grow at a 6% compounded rate for the next 10 years, with growth tapering down towards the growth rate of the economy in the long term. 
3. Product life cycle: The life cycle for a new iPhone will continue to be two years and Apple will have to reinvest half its after-tax operating income in the second year of each cycle (this 50% also incorporate the lost sales in the second year, as each iPhone ages and customers wait for the next version).
4. Switching assumptions: iPhone customers are assumed to be loyal, with only 5% switching to competitors' products at the end of each life cycle. Apple will be more successful at attracting competitors' customers, with 10% switching into iPhones. 
5. Risk: Needless to say, there is substantial risk in this process and the cost of capital of 11% (at the 90th percentile for US companies) reflects that risk.

The value that I estimate for the iPhone franchise is $307 billion, working out to a multiple of 3.39 times revenues and about 16.17 times net income on the iPhone. You can download the spreadsheet that I used and change the assumptions, if you so desire. In fact, as with my Groupon and Facebook valuations, I have opened a shared Google spreadsheet for you to enter your estimates of value for the iPhone franchise.

Here is the larger point, though. About 55% of Apple's business value comes from its iPhone franchise and there are three pressure points that will test this value.

• The first is Apple's capacity to maintain pricing power and earn its current margins; there isn't a competitor within shouting distance of Apple, when it comes to margins. If the after-tax margin drops to 15% from its current 21%, the value of the franchise drops to $219 billion.
• The second is that Apple will be able to prevent the life cycle from speeding up further and that it can continue to innovate at a reasonable cost (with this cost in conjunction with the loss in earnings during the second part of the cycle not exceeding 50% of the after-tax earnings during the period). Reducing the life cycle to one year from two almost halves the value of the franchise.
• The third is that Apple is able to maintain a net positive switching ratio (more of the competitors' customers switch to Apple than vice versa), allowing it to increase in market share in dollar value terms. Assuming a neutral switching ratio (customers switching in = customers switching out), reduces the value of the franchise to $255 billion. 

There is an internal tension between these three variables, since keeping iPhone prices high (preserving the high margins) and spending less on innovation (reducing the cost of innovation) may increase the risk that more customers will switch away than into the iPhone. Using the "life cycle" model also provides some perspective on why the lawsuit victory against Samsung may have a bigger effect on the value of the iPhone franchise than how the iPhone 5 fares with customers in a few weeks. Samsung's loss will have a deterrent effect on competitors planning an assault on the iPhone kingdom, thus increasing Apple's pricing power (preserving margins) and improving its odds of holding on to its customers (improving its switching ratio).

With the iPod, iPhone and iPad, the company has been able to count on the unmatched loyalty of its customers, while both attracting customers of less innovative competitors and increasing overall market size. The question that investors face right now is whether Apple can continue its winning streak. The high valuations attached to the company assume that the company can keep doing what it is right now, that the iPhone 5 will not only launch successfully, but be followed by the iPad Mini and the iPhone 6 and so on. The risk that investors have to take into account when investing in Apple is that somewhere along the way, the winning streak may will be broken. Unlike other large market cap companies with long product life cycles or diversified product portfolios, Apple’s value rests on being a Phoenix, constantly reinventing itself every few years.

Groupon Gloom: Deal of the day or Death Spiral?

In keeping with this week's theme of revisiting ghosts of valuations past, I decided to take a look at another fallen angel, Groupon. The stock has collapsed to $4.44 from its post-IPO high of $29 and investors and employees seem to be fleeing from the exits. If you are a contrarian with a strong stomach, it would like the stars are aligned for some bottom fishing but is Groupon a buy, even at this discounted price?

To make this assessment, I decided to take a look at my posts on Groupon from last year:

1. In my very first post on Groupon in June 2011, I looked at their attempt to move customer acquisition costs from the operating expense to capital expenditures column. While I was sympathetic to the general argument that operating expenses that create benefits over many years (such as R&D, exploration costs and even customer acquisition expenses) should be treated as capital expenditures, I was skeptical in Groupon's case since there was little evidence that Groupon's acquired customers stayed on for long periods and also because Groupon did not follow through fully and treat customers as assets (and amortize or depreciate these assets over time). 
2. In my second post in October 2011, I looked at Groupon (as well as Google and Green Mountain) with an eye towards potential growth, using four tests: the feasibility of the growth given the overall market served by each company, the capacity to scale up growth (i.e., maintain growth as the companies get bigger), the value created by that growth and the effect of management credibility on how the market perceives that growth.  
3. In my third post on November 2, 2011, I valued Groupon at the time of the acquisition. Using  "aggressive" assumptions on revenue growth (50% annually for first 5 years, scaling down to mature growth by year 10) and pre-tax operating margin (23%), I estimated a value of $14.62 per share, below the $16-$20 range that investment bankers were touting.
4. The stock did go public on November 3, 2011, at $20/share, and jumped to $28 by the end of the day. My fourth post on Groupon, on November 4, 2011, looked at the company in the context of a discussion of the value of growth. For growth to add value, I argued that it has to be accompanied by "excess returns", which, in turn, require competitive advantages or barriers to entry. Looking at Groupon's business model, I could not think of any significant barriers to competition that would prevent others from entering the market and eating away at Groupon's margins. Using a simulation, I estimated the following distribution for value/share for Groupon in November 2011 and argued that the stock was more likely to be worth less than $10/share than it was to be be worth $30:

A year later, it is clear that I under estimated how quickly any competitive advantages that Groupon's first mover status gave them would be eroded. This is clear not only from perusing my email box every morning (and removing the dozen emails from different deal-of-the-day purveyors) but also in Groupon's financial results. As the most recent earnings report makes clear, revenue growth has slowed, profitability has lagged and the stock price collapse is in reaction these changes.

As I revisited my valuation, as with Facebook, I had to caution myself not to overreact, but the news, as I see it, is far more dire for Groupon than it is for Facebook. While Facebook's results were disappointing in terms of converting potential to profits quickly, the potential (from their vast user base and the information they have on these users) still remains. In Groupon's case, where the business model was clearer at the time of the IPO, the business model has collapsed and it is difficult to see what the company can do to set itself apart from the competition and make money at the same time. As a result, the changes I made in my Groupon valuation are more dramatic than the changes I made in my Facebook valuation. My base year numbers reflect their most recent quarterly filing, with trailing 12-month revenues of $1.965 billion and operating income of $71 million. My forecasted revenue growth rate is 25% (leading to revenues in 2022 of $10.3 billion, as contrasted with my earlier forecast of $25.4 billion), my target margin is 12% (down from my year-ago estimate of 23%) and my sales/capital ratio is now down to 1.25 (from a year-ago estimate of 2.00). The end result is a value per share of $4.07, which makes the stock, at best, a fairly priced stock. In fact, if you bring in the likelihood that the firm may not make it through its growth pains in the spreadsheet, the value per share drops even further. As with the Facebook valuation, you can download my spreadsheet and put your own estimates in... I have a shared Google spreadsheet for those of you who want to share your numbers...

There are two broader point that are worth making here.

1. A dramatic stock price drop is not always a buying opportunity: Most young growth stocks are subject to gyrations and it is not uncommon to see growth stocks plummet, when they don't meet the lofty expectations that investors have for them, and we have seen this happen to both Facebook and Groupon. In some cases, investors over react and push the price down far more than they should and that is the basis for my pitch I made for friending Facebook in my last post. In some cases, though, the stock price collapse is well-deserved and that is my rationale for avoiding Groupon. 
2. Intrinsic valuations can (and should) change over time: There is deeply held belief, at least in some quarters, that intrinsic valuations are stable and don't change over time. While that may be true in many companies and most time periods, there are three exceptions. The first is a dramatic change in the macro environment. My intrinsic valuations for almost all companies changed between August 2008 and October 2008, as the market price of risk (in the form of equity risk premiums and default spreads) increased dramatically in the aftermath of the banking crisis. The second is when accounting fraud is uncovered and key numbers have to be restated. The third is with young growth companies where the premise on which the value of growth is based - that it is scalable, defensible and valuable - is called into question. It is the third exception that applies to Groupon and I feel comfortable lowering the value per share from $14.82 a year ago to $4.07 today. 

Facebook face plant: Time to friend the company?

Facebook returned to the headlines on Friday, after it's stock price dropped below $20. At it's closing pricing of $19 on August 17, Facebook was trading at roughly half it's IPO offering price. Investors, analysts and journalists are all looking for the reason for the collapse and some at least seem to have found a ready target: the price drop, they argue, is the result of the "unlocking" of restrictions on insiders selling shares. The problem with this explanation is that it has never been a secret that insiders in Facebook would be able to sell shares starting August 16 and I would wager that no one would have even noticed the end of the lockup period, if the IPO had gone well and the stock were trading at $ 55/share. So, what is going on with Facebook? Why has its stock price plunged over the last few weeks? And is the stock cheap at $19?

The story so far...

As we look back at 2012, it is quite clear that Facebook has held us in its thrall (and not always in a good way) through much of the year and my posts over the year on the company reflect that fascination. Rather than cover up my paper trail, let me draw attention to it (warts and all):

1. S1 Filing (February 2012): In my first post on Facebook this year, right after Facebook filed its financials (S1) with the SEC, I valued Facebook at $28/share (or $70 billion). I based this valuation on the company's immense potential (its vast user base and the information it had about these users), but was concerned about the absence of a clear business plan (to convert users to revenues), the overhang from insiders stockholdings/options (yes, you could see the lock up period ending in February) and the abysmal corporate governance. 
2. Playing the IPO pop game (February 2012): In response to a wave of articles that seemed to suggest that investing in the Facebook IPO (at the offering price) would be a sure road to profit, I tried to provide some history on the IPO game in my second post on Facebook, noting that while it was was true that investing in the average IPO does generate a pop for investors, this pop is not guaranteed and that the IPO game can be a loser's game. 
3. The day before the IPO (May 2012): On the day before the IPO, I posted on what I saw as the hubris of those involved in the IPO process - the investment bankers, the company (Facebook) itself and the institutional investors, who all seemed to think that they could lead the market by to wherever they wanted to go. I updated my valuation of Facebook to about $27 a share and contended that the stock would open with a relatively small pop (that the bankers would get the pricing right) but that the stock was overvalued for longer term investors.
4. The post-IPO assessment (May 2012): The stock opened (late because of the NASDAQ technical problems) at about $42 and very quickly lost ground over the day to end the day at below the offering price.  I posted my rationale for the momentum shift and argued that a great deal of the blame could be laid at the feet of the company and its bankers, who essentially took momentum for granted. I also ended the post by arguing that the switch in momentum could very well lead take the stock in the other direction, from over valued to under valued.

An updated valuation

If Facebook was over valued at $38, relative to the estimated value of $27/share, is it under valued at $19? To address this question, I revisited my Facebook valuation from May and looked at what I have learned about the company (for the better or worse) since. Has there been enough information that has come out about the firm that could have caused the intrinsic value (at least as I measure it) to drop below $19? The biggest piece of financial information that has emerged on Facebook has been one quarterly earnings report a few weeks ago and it seems to me that not much has changed on either side of the ledger since February. The earnings report was a disappointment to markets, revealing less revenue growth than anticipated and an operating loss, largely as a result of share compensation expenses that were recognized when restricted stock units owned by employees were recognized at the time of the IPO. Facebook remains a company with vast potential (their user base has not shrunk), no clear business plan (is it going to be advertising, product sales or something else) and poor corporate governance. I had not expected any of these issues to be resolved in the one quarterly report and they were not. I did make some adjustments to my valuation: (a) lowering my revenue growth (with my 2022 revenue estimates dropping by about 10%, relative to my May estimates, (b) reducing the operating margin from 35% to 32% to reflect the higher expenses and (c) reducing my sales to capital ratio from 1.50 to 1.20 to incorporate the higher cost of acquisition driven growth. With these changes,  my intrinsic value for Facebook with the updated information is $23.94, a drop of just over 10% from my May 2012 estimate.

So, why did the price drop so much? There are several possible reasons. The first is that my estimate of intrinsic value is completely wrong, that the true value for the company has always been in the low teens and that the market is correcting its initial mistake. The second is that most investors in Facebook don't know what the value of the company is and don't care a hoot about it. Instead, they are pricing (rather than valuing) the stock, reacting to the "surprise" in each news story and to how other investors in the market are responding to that story. This, after all, is the nature of momentum investing, with positive surprises getting magnified by the crowd into unrealistic price jumps and the negative surprises into catastrophic drops. I know that analysts have turned bearish on the stock but since many of these analysts assured me that Facebook was a steal at $38/share, I am not inclined to put much weight on their prognostications. In fact, they very fact that they are turning against the stock may be a positive indicator.

Time to buy?

Now that the stock is at $19, about $5 below my estimate of intrinsic value, would I buy? To make that judgment, I considered three factors.

1. My value could be over stated: I understand that this is a risky investment and that my estimate of value could be hopelessly wrong. In fact, I followed up my intrinsic valuation with a simulation, where I looked at the distribution of intrinsic value, allowing revenue growth, margins and cost of capital to vary. 

Based on my assumptions, there is an 80% chance that the stock is under valued at $19 a share and an almost 85% chance that it is under valued at $18 a share.

2. Management is not going to change: The corporate governance issue is the one that I have the most trouble overcoming. The structure of the voting rights in the company ensure that there is little that stockholders can do to influence how this company is run and that can be a potential problem if it locks itself into a self-destructive path. Calling for Mark Zuckerberg to step down or share power, as an article in the Los Angeles times did, are completely unrealistic. The Russians have a better shot at getting rid of Vlad Putin than Facebook stockholders have of displacing Zuckerberg. For some, this may be a deal breaker, and it came close to being one for me.

3. Vindication, even if I am right, will not come quickly: Markets know no fury to match that of momentum investors scorned, and these investors tend to turn with a vengeance on the companies that disappoint them. Put in stark terms, it is entirely possible that my valuation of Facebook could be right but that the stock price could continue to keep dropping as investors bail out. Eventually, the "intrinsic" truths will emerge, but it may be a long time coming. 

My conclusion is that Facebook is not quite at the threshold of being a buy yet, but it is getting close. I have a limit buy order for the stock at a price of $18. I would be interested in seeing where you stand on the stock and you are welcome to enter your estimate of intrinsic value for the stock and your threshold for buying the stock in the shared Google spreadsheet.

Revolutionary watch crowdfunded in weeks after years in business finance wilderness

After spending years trying to raise venture capital for his innovative new watch project,  Eric Migicovsky  finally tried crowdfunding as a last resort. One of his friends recommended it after his own success in raising funding. He read up on the best approach to crowdfunding, decided on a list of goal amounts and related rewards and posted his project on Kickstarter, arguably the most successful crowdfunding platform to date. The result? Pebble Watch got $500,000 in funding after one day on Kickstarter.com.

  Speaking in Boston at the World Congress Leadership Summit on Telemedicine at the Colonnade Hotel today, Eric Migicovsky, Founder and Lead Designer at Pebble Technology, described years of fruitlessly seeking enough investment capital to support the launch of his team’s invention, a customizable watch, only to be completely funded within weeks through crowdsourcing on Kickstarter.com. In fact, on the first day on Kickstarter, his team made five times their original goal of $100,000.

The Pebble Watch is programmable, customizable, and integrates with iPhone and Android. This makes it possible to connect the watch with health apps designed to support patients with chronic diseases, such as diabetes. Patients could program in alerts to take medication, as well as use sports and fitness apps to help them keep healthy and even lose weight.

“Apps can be prescribed to patients,” explained David Barnes, Strategic Advisor at Happtique. His company has designed a proprietary method for mobile devices, such as the Pebble Watch, to transmit health care data securely. Happtique is also developing an app certification program “Blue Ribbon Panel” that would make sure health applications using mobile devices such as the Pebble Watch meet standards such as operating reliably, having valid health information, and safeguarding data.

Does the Pebble Watch’s success on Kickstarter after its failure to obtain traditional investment, show that crowdfunding is the  new sollution for breaktrough concepts and entrepreneurial support, asks Candace Klein.

One of the key reasons for the success of crowdfunding is that smaller projects of $25,000 to $50,000 could easily be funded by crowdsourcing but would be too small for venture capitalists to consider, she points out. In addition, if a larger effort can demonstrate that it can raise some portion of its funds from crowdsourcing, investors will be encouraged that the project has popular appeal.

Following the success of the websites such as www.Kickstarter.com, www.crowdcube.com and www.indiegogo.com/ it will be interesting to see the level of sucess South Africa's own www.Startme.co.za  will manager to achieve.

Earnings surprises, price reaction and value

The earnings season is upon us and each company’s earnings announcement is eagerly awaited, traded upon and talked about. For widely followed companies like Apple, the obsession with what the next earnings report will deliver overwhelms any sensible assessment of what it means for the company. But is this obsession merited? Do earnings announcements have significant effects on value? If so, why? More importantly, can you make money off earnings announcements? 

The “Announcement” Process
To understand how and why earnings reports matter, we should start by looking at the process. Publicly traded companies are required to report on their performance at “regular” intervals. In the US, the reports have to come every quarter, with full financial statements filed with the SEC. The degree of disclosure varies across markets, both on timing (quarterly, semi-annual and annual) and on information (partial reports of performance in some regimes).

The reporting ritual is highly scripted, at least in the US, in terms of timing (companies report earnings on about the same date every year, give or take weekends, and in the same format to allow for year to year comparisons). The initial report provides the bare bone details (revenue growth, earnings per share and a breakdown of a few extraordinary items) and is followed a few weeks later by the full filing of the quarterly report (10Q) with the SEC.

Since earnings reports contain information that can affect prices, the SEC does regulate trading and disclosure around the reports. Insiders are restricted from trading before earnings announcements and Regulation FD bars firms from providing information about upcoming earnings reports to subsets of investors (analysts). In theory, at least, the information in an earnings report should be “news” to markets.

Companies may be restricted from providing information selectively to analysts following them, but this does not prevent analysts from forming and propagating their expectations about what the earnings report will contain to their clients and, by extension, the public. In fact, a substantial portion of a typical equity research analyst’s time is spent on the “earnings forecasting” exercise, and there are services that assess analyst quality by looking at how close the forecast comes to actual numbers. In the US, services such as Zacks and I/B/E/S that track and report analyst forecasts of earnings and you can find them in the public domain (Yahoo! Finance or similar sites)

The Expectation Game
When a company does report its earnings, markets will react to the “news” in the report but the way we measure the news has to be relative to expectations. Thus, a company that reports that its earnings went up by 30% may be seen as delivering bad news, if investors were expecting an increase of 40%, and a firm that announces an earnings decline of 30% may be providing positive information, if the expectation was that earnings would decline by 40%. Thus, it is not the magnitude of the earnings change that matter but the “surprise” in the earnings, measured as the earnings change relative to expectations.

But how do you measure expectations? One obvious answer is to use the analyst estimates of the earnings and news reports like this one generally compare the earnings change to the “consensus” estimate of earnings change to frame the report. A second is to use the “past” earnings growth for the company as a measure of expected earnings growth. With either measure, then, a positive (negative) earnings surprise then becomes an earnings report where the actual earnings per share exceeds (falls below) the expected value (using consensus earnings estimates or historical earnings growth).

While you can use analysts or history as the basis for estimating expected earnings, the market expectations process is a more nuanced one and more difficult to model. In the last two decades, firms have become more attuned to playing the earnings game, and have become increasingly adept at beating earnings expectations by playing both sides of the game. First, they work on analyst expectations, using selective leaks to bring expectations down, prior to earnings reports. Second, they work to mold the actual earnings, using both accounting choices (earnings management) and operating discretion (timing of R&D expenses, for instance) to deliver results that beat expectations. The problem with this game is that markets catch on and adjust expectations accordingly.

The Announcement Effect
If you can measure earnings expectations, an earnings surprise should have an effect on stock prices, with positive (negative) surprises evoking positive (negative) responses. The earliest studies of earnings surprises used historical earnings to estimate expected earnings and found backing for this hypothesis. In more recent studies, consensus estimates of earnings have been used to measure expected earnings. The following graph captures the announcement effect of earnings surprises, categorized from most positive to most negative, with expectations measured as consensus estimate from analysts:

There are three interesting findings embedded in this graph. 

1. Pre-announcement drift: There is a mild drift in stock prices before earnings reports that is consistent with the eventual surprise: prices move up before positive surprises and down before negative surprises. I will let you make the judgment on whether this is evidence of insider trading, investor prescience or some combination of the two. 
2. Announcement effect: The announcement still contains news. On the announcement, the price effect reflects the magnitude and the direction of the surprise, with stock prices going up about 3%, on average, in reaction to the most positive surprises.
3. Post-announcement drift: The most surprising finding is that stock prices continue to drift after the announcement in response to the surprise. The graph below looks at the price drift in the 30 days after the announcement:

Differences across firms
There are studies that indicate that the returns associated with earnings surprises are more pronounced with some types of stocks than with others. For instance,

1. A study of value and growth stocks found, instance, that the returns in the three days around earnings announcements were much more positive for value stocks (defined as low PE and PBV stocks) than for growth stocks across all earnings announcements – positive as well as negative. This suggests that you are much more likely to get a positive surprise with a value stock than with a growth stock, indicating perhaps that markets tend to be overly optimistic in their expectations for growth companies. 
2. Earnings announcements made by smaller firms seem to have a larger impact on stock prices on the announcement date and prices are more likely to drift after the announcement. 
3. As with analyst reports, there seems to be evidence that the market reaction to earnings reports is a function not only of the earnings number reported but also the accompanying management commentary.
4. There is some evidence that the market reaction to earnings reports is greater at firms with high institutional ownership, with one rationale being offered that institutional investors tend to be more short term in their focus and thus more likely to respond to quarterly earnings reports.

There is one final aspect of the earnings game that may be affecting stock market reactions. As firms become adept at playing the game, managing expectations and tweaking earnings to beat expectations, investors have adapted. Firms that consistently beat consensus estimates now have to beat them by a "margin" (based upon their past history) to register a positive surprise. This is of course the phenomenon of "whispered earnings". With the Apple announcement due later today (July 24, 2012), the consensus earnings estimate is for earnings per share of $10.35 and the whispered earnings estimate is 67 cents higher at $11.02. The only problem is that Apple has beaten whispered earnings 42 out of the last 56 quarters. It is only a matter of time, I guess, before you have whispers on top of whispered earnings. My head hurts just thinking about the possibilities.

Playing the Earnings Game
So, how can investors play the earnings game? Using the earnings surprise graph as the basis for the discussion, here are some of the possible paths.
a. Predict the surprise: You can try to devise ways of forecasting positive or negative surprises before they occur. I know it is easier said than done, but to the extent that you can stay on the right side of the insider trading law and find advance indicators of upcoming surprises (trading volume changes, price patterns etc.) you can profit.
b. Trade on the news: To take advantage of the drift after the news, you could buy stocks after exceptionally positive earnings announcements and sell short on stocks after terrible earnings reports. Given that the drift is about 2-3%, don't expect this to do much more than augment returns at the margin. You could of course load up and use options to leverage the profits, but...

c. Play the earnings momentum game: While the first two strategies are short term, there is a longer term strategy that can be built around earnings reports. Studies indicate that companies that have consistently beat earnings reports over the last few quarters deliver higher returns in subsequent periods. Thus, in addition to screening for high quality growth and low risk, you can also screen for earnings momentum.
d. Intrinsic value assessment: As a believer in intrinsic valuation, I look for ways to tie the information in earnings reports to intrinsic value. To do that, though, you need to look past the top line news (earnings per share) and at the underlying details (revenue growth, operating margins and return on capital). If you do so, you may very well find  a report that looks positive on the surface (because the actual earnings exceed expectations) but contains enough negative news (lower revenue growth, declining margins and return on capitals) to cause intrinsic value to decrease. If the market misreads the report as "good" news and the stock price jumps up, you have the makings for a contrarian play.

So, here is the challenge. By the time you read this post, the Apple earnings report will have been made public. Evaluate it and make your judgment on how (if at all) you will incorporate it into your investment strategy for Apple. I have attached my intrinsic valuation of Apple (made before the earnings report came out) with suggestions on how to incorporate the information in the earnings report into value. Take your best shot!

Equity Risk Premiums: Globalization and Country risk

The equity risk premium reflects what investors expect to earn on equities, as a class, over and above the risk free rate. Implicit in that definition are two key points. The first is that the equity risk premium is a macro number that applies to all stocks. The second is that the equity risk premium is the receptacle, in intrinsic valuation, for all macro economic fears. In fact, I used the equity risk premium as my vehicle for talking about how economic crises (the US rating downgrade of last summer, the Greece default dance…)

On my web site, I update the equity risk premium for the S&P 500 every month, with my latest update of 6.17% on June 29, 2012. Even if you accept that estimate as a reasonable one for the US, there are many other estimation challenges. If you are valuing a Brazilian company, what equity risk premium would you use? What if you are valuing a multinational like Siemens or GE, with significant revenues in emerging markets, or an oil company with substantial reserves in Nigeria? More generally, in the face of globalization, valuing any company now requires an understanding of how best to evaluate country risk and convert into appropriate equity risk premiums. If you are working for a multinational, understanding how equity risk varies across countries is central to coming up with hurdle rates that vary across countries and lead to a fairer allocation of capital.

Should equity risk premiums vary across countries?
The question of whether equity risk premiums should be different for different countries, at first sight, looks like it has an obvious answer. Of course! After all, Venezuela, Russia and Greece are riskier countries to invest in than Switzerland, Germany or Canada and should have higher equity risk premiums. The answer, though, is not that simple. There are two scenarios where country risk will cease to matter and you will use the same equity risk premium for all companies, no matter which country they operate in. The first is if country risk is idiosyncratic, i.e., specific only to that country, with no spill over effects. If this is the case, diversifying geographically across countries should make this risk disappear in your portfolio, which can be accomplished by companies expanding their reaches across the globe (think Coca Cola or Nestle), or easier still, by investors holding geographically diversified portfolios. The second is to assume that all investors invest in global portfolios, in which case you could compute a global equity risk premium, capturing macro economic risks around the world, and estimate betas for individual companies against a global equity index.

Both assumptions are difficult to sustain. The assumption that country risk is diversifiable is built on the presumption that the correlation across countries is low and that there is no contagion effect. That may have been true in the 1980s but as investors and countries have globalized, the correlation across countries has risen. Put differently, country risk is no longer diversifiable and requires a risk premium to those exposed to it. The assumption that investors are global is more reachable now than two decades ago, but institutional restrictions (Indian and Chinese investors still cannot invest easily overseas) and investor behavior (there is a substantial home bias in portfolios, where investors over invest in their domestic markets) still stand in the way.

Bottom line: I think that equity risk premiums do vary across countries, with higher equity risk premiums applying to riskier countries. Applying the same equity risk premiums across companies will lead you to over value companies that have higher exposure to emerging markets.

How do you estimate equity risk premiums for different markets?
If you accept the premise that equity risk premiums should be different for different market, the question of how best to estimate these premiums follows. You cannot obtain these premiums using historical data, i.e., by looking at the premiums earned by stocks over riskless investments within each of the markets. Why not? First, there may be no riskless investments in many of these markets, either because governments may have default risk or because government bonds were not issued/traded over the period. Second, these markets are changing so much over the historical period in question that the historical premium you get over the period is not a predicted premium. Third, and more important, equity markets are volatile and the equity risk premiums over 20,30 or even 50 years of data have estimation errors that drown out the estimate.

Here are three alternatives that can be used to estimate the equity risk premiums for other markets:
A. Country default spreads: The simplest approach is to start with a mature market premium (say, 6% for the US), and then augment it by adding a country default spread for the country in question. That default spread can be estimated in one of three ways:

1. Government bonds in US$/ Euros: If the country in question has dollar or Euro denominated bonds, you can estimate the spread over the US treasury bond or the German ten-year bond rate respectively. 
2. Sovereign rating: Moody’s, S&P and Fitch all assign sovereign ratings to countries. You can estimate a typical default spread, based on the sovereign rating, using a lookup table that I update at the start of each year. Using Peru as an example, the sovereign rating of Baa3 for the country yields a default spread of 2.00%. Here are the latest local currency and foreign currency sovereign ratings from Moody's.
3. CDS spreads: The Credit Default Swap market is of more recent origin, but it is a market that allows you to buy insurance against default risk (see my earlier post on this market). Thus, if you bought a 10-year Peruvian government bond with an interest rate of 4.5%, and were concerned about default, you could have bought a 10-year Peruvian CDS. The price of that CDS in June 2012 was 2.06%, effectively implying that you would need to pay 2.06% out of your 4.5% each year for the next 10 years to get default protection. If you are interested, here are the ten-year CDS spreads for all of the countries where they are offered as of June 30, 2012. 

B. Relative Equity Market Volatility: In this approach, you can scale up the equity risk premium for the US by the relative volatility of the country in question, with relative volatility computed as the ratio of the volatility of that market to the volatility in the S&P 500. Thus, if standard deviation of Peruvian equities is 21%, the standard deviation for the S&P 500 is 15% and the equity risk premium in the S&P 500 is 6%, the equity risk premium for Peru will be
Equity Risk premium for Peru = 6% (21%/15%) = 8.4%
Country Risk premium for Peru = 8.4% -6% = 2.4%
While this approach has intuitive appeal, its weakness is that the equity market volatilities are as much a function of country risk as they are a measure of liquidity, with less liquid markets (which are often the most risky) having higher standard deviations. Here are my estimates for emerging markets as of January 2012.

C. Scaled Default Spread: In this approach, you combine the first two, by starting with the country default spread in approach 1 and then scaling it for relative volatility, but this time of the equity index in the country to the volatility of the government bond in that country. Again, using Peru as the example, assume that the standard deviation in the Peruvian government bond is 14% and that the standard deviation in Peruvian equities stays at 21%:
Default spread for Peru = 2.00% (using the rating)
Country risk premium for Peru = 2.00% (21%/14%) = 3.00%
Total equity risk premium for Peru = 9.00%
By staying within the same market for both volatilities, this approach is less susceptible than the prior one to liquidity variations across markets. The standard deviations can be noisy or difficult to estimate and I prefer to use a median value for the ratio across markets, rather than the ratio for any given market. (See my January 2012 update of equity to government bond volatilities.)

There is one other approach, where you are not dependent upon knowing the mature market premium, historical volatilities or default spreads. You can compute an implied premium for an emerging market, based upon the level of equity prices and expected cash flows. While this is what I do for the S&P 500 each month to get the implied premium for the US, it is far more difficult to use in emerging markets, because of data limitations.

Where do you use this equity risk premium?
Equity risk premiums come into play at every step in investing. At the asset allocation stage, where you determine how much of your portfolio you will be allocating to different asset classes (equity, fixed income, real assets) and to different geographical areas, you have to make judgements of which markets you are getting the best risk/return trade off and allocate more money to those markets.

Once you have made your asset allocation judgments, equity risk premiums come into play, when you value individual companies. In intrinsic or discounted cash flow valuation, you need the equity risk premium to get to a cost of equity and capital. The common approach, among many practitioners, is to attach an equity risk premium to a company, based upon its county of incorporation. Thus, when valuing Peruvian companies, you would use 9.00% as your equity risk premium, thus pushing up your cost of equity/capital and pushing down value, and when valuing US companies, you would use the 6% (mature market premium). I would suggest a more nuanced approach (which will take a little more work): compute an equity risk premium for a company that reflects a weighted average of the countries it operates in, with the weights being based upon an observable variable (revenues seem to work best). Thus, if you are valuing a company with 30% of its revenues in Peru (ERP =9%), 30% of its revenues in Venezuela (ERP =12%) and 40% of it revenues in the US (ERP =6%), you would use the following:
Weighted average equity risk premium = .30 (9%) + .30 (12%) + .40 (6%) = 8.7%
If the company breaks down revenues into regions rather than counties, you may have to compute a premium by region (Latin America, South Asia, Eastern Europe, Sub-Saharan Africa etc.) and take a weighted average.

In relative valuation, the use of country risk is usually implicit or qualitative. Thus, when comparing the PE ratios for oil companies, you may choose not to buy Lukoil, even though it trades at a lower PE than Conoci, because you worry about Russian country risk. If you want to be more explicit about how much to adjust multiples for country risk, download my spreadsheet for computing intrinsic multiples and change the equity risk premium to see how much PE or EV/EBITDA multiples change as the equity risk premium changes.

My latest update
I update country risk premiums, by country and region, at the start of every year. Given the turmoil of the last six months, and dramatic changes in country risk (especially in Europe), I have updated the numbers as of June 30, 2012. You can get the latest version of my estimates of country risk premiums by clicking here. If you want a blow-by-blow account of my reasoning on equity risk premiums, you can be a glutton for punishment and download my paper on equity equity risk premiums (the 2012 version).