Love the company! Love the product! Love the stock? An Update on Apple

My first computer was a Mac 128K. I was a budget-constrained doctoral student from UCLA, teaching my very first class at UC Berkeley. At $2,500, in 1984 dollars, it consumed all of my discretionary income for that year, but it was love at first sight. Having sampled what the PC world had to offer, with its collection of geek speak and inscrutable illogic, I was dazzled by the human interface of the Mac and impressed with the creative spirits that ran the company (Steve Jobs & Steve Wozniak). Suffice to say, I was a Jobs fan, before it was fashionable to be one.

As I watched the evolution of the Mac through the decade, I learned some lessons that I have tried to hold on to in my investing and that came to mind last week, as I read some of the comments on my Tesla valuation.

1. Even great CEOs have their blind spots: The success that Steve Jobs had at Apple, in his second coming as CEO, had made us forget his missteps in his first iteration as Apple's head. His creativity and focus were still there in the 1980s but I think that his zeal to put his personal imprint on style and features overwhelmed any sense of what the market wanted or needed at the time. The Mac Lisa, in my view the most ungainly of Apple computers ever, stands as testimonial to that era and to Job's lack of market discipline.
2. The best technology does not always win: Much as I would like to believe that the best technology wins out in the market place, I learned to my consternation that this was not always the case. After all, not only did Microsoft win the operating system battle against Apple, with a vastly inferior system (in my biased view) but VHS beat out beta in the videotape stakes. Success in the market place requires a lot more than a good product: a recognition of what it is the market wants, good timing and good luck!
3. Good companies are not always good investments: When I an enamored about a company, I have to remind myself to separate my views of a company from my views of its stock as an investment. After all, the evidence from history is sobering. As I noted in this earlier post on value investing, the better regarded a company is by the market place, the worse it is as an investment. 
4. It is difficult to maintain distance when you love a company and its products: Much as I would like to be objective and unbiased, I am human. When I value a company, I start with preconceptions and views that find their way into my numbers, no matter how hard I try. As I noted in this very first post I had on Apple from early last year, all that I can do is be transparent about my biases and let you make your own judgments on whether you buy into my assumptions.

I have a long and complicated relationship with Apple, both as a user and as an investor. As a user, I have bought almost every version of the Mac (except for the Lisa) that has come out since 1984 and will probably add the new version of the Mac Pro to the list this fall. As an investor, I steered away from Apple as an investment through the much of the 1980s and 1990s, partly because I knew that my bias would blind me to the facts. In 1997, I succumbed and bought Apple stock (the split adjusted price was just over $5) just as the company faced its darkest days, as questions mounted about whether the company would make it in a world where Microsoft seemed to have won the PC wars. I would love to tell you that I bought the stock for intrinsic value reasons (because it would make me look good) but as I noted in a post from a little over a year ago, I did not. Instead, I bought the stock out of compassion and loyalty, the former driven by the feeling that the stock may not make it and the latter by the joy its products had delivered to me over time.  That “charitable” contribution turned into my best investment ever, a fact I remember whenever I have moments of hubris about my valuation skills. 

That investment stayed in my portfolio until April 2012, when the company’s stock price hit $600 and the market cap looked like it would climb inexorably towards a trillion, I revalued the company (as I am wont to do with every company in my portfolio, at regular intervals). While the value I obtained was close to $700, I decided that it was time for me to cash out, even though the company was undervalued (at least based on my assessment). I justified  that decision in my post on Apple at the time, arguing that the momentum investors who had come into Apple had made it a pricing play and that I was not skilled at that game. In late August 2012, as the hype for the iPhone 5 built up and the stock price hit $700, I posted a valuation of just the iPhone franchise and argued that it was the most valuable franchise in history. 

Early this year, as Apple’s stock price converged on $450, I revisited my Apple valuation to see if I could justify the sudden and dramatic loss of almost $200 billion in market capitalization from a value perspective. Even allowing for the tighter margins and the stronger competition (from Android phones) my assessment of value for Apple was about $600. Arguing that the price drop had driven some (but not all) of the price and momentum players of the game, I made the decision to become an Apple stockholder again. As I made that decision, I wondered how much of it was driven by my residual bias towards the company and its products.

In May 2013, after feeling some outside pressure from activist investors and their proposals for enhancing price (with David Einhorn’s well publicized push for the company to issue preferred stock, which I responded to in this post), the company announced its intentions to borrow money for the first time in its history and to augment its stock buybacks. I argued at the time that while these actions would have a relatively small impact on value, which I estimated to be $588 at the time, they might be the catalysts that caused the price to move towards the value.

I was clearly way too optimistic, since the stock continued its descent hitting a low of $385 in April. As the price dropped, I did hear from a lot of the readers of my blog post, asking me whether I was reconsidering my decision. The essence (and appeal) of value investing to me is that if you buy a company for its capacity to deliver cash flows to you as an investor, the fact that the market moves against you should change nothing. I would be lying if I said that I was unaffected by the price moving in the wrong direction, but Apple stayed in my portfolio. In the last few weeks, we have seen a piling on of big name investors (Carl Icahn, Leon Cooperman) into Apple and the stock price has risen back to close to $500. To those who have asked me how that has affected my value, I would argue that nothing that Mr. Icahn had said since he took his stake in the company is a revelation that changes my fundamental assessment of value.

Apple’s big announcement date is tomorrow, at 10 am. If you are investor (long or short, potential or current), here are my suggestions. 

1. Ignore the lead-up to the announcement, with the rumors, stories and opinion that you will see thrown around. Much of it is hot air with no effect on value. 
2. If you can avoid it (and it will be tough to do so), don’t watch or listen in on the Apple announcement and try not get caught up in the frenzied trading that will inevitably follow. 
3. I updated my valuation of Apple to reflect the financials as they stand today. Incorporating the information in the last annual report and markets (US treasury bond and equity) as they stand today, my estimate of value is $617, about 4% higher than my estimate in April 2013. A factor contributing to the increased value per share is the decline in the number of shares outstanding from 939.6 million to 908.4, a logical consequence of Apple's aggressive stock buyback program. 

Once you have the details of the announcement, go through the news stories with a singular focus on how they will impact Apple’s revenue growth path, operating margins and investment requirements for the future. The key is to not only separate the wheat (information) from the chaff (distractions) but also to work out the consequences for value.

As an Apple investor, I will be doing the exercise as well to see the implications for my Apple holding. While it is always dangerous to prejudge a news story, I don’t think that anything that comes out tomorrow will be game changer when it comes to value, though it may very well move the price (and I have absolutely no idea in which direction), especially if, as is rumored, it will revolve primarily around the iPhone and the iPad. As I noted in my last post on Apple, I believe that Apple’s value creation over the last decade has come from its capacity to disrupt existing businesses and that Apple is now too large a player in both the smartphone and tablet businesses to be a disruptor. In fact, I think that they face a bigger risk in both businesses of someone else disrupting their cash cows. It would be exciting and potentially value changing if Apple announced a new market that they were planning to enter that no one expected them to. In my last post on Tesla, I argued that one of the potential positive scenarios for a Tesla bull was a strategic buyer who would be able to pay a premium over $20 billion. While I named automobile companies as potential buyers, there is no reason why that buyer cannot be a technology company with a large cash balance. Apple clearly has the cash and if it can figure out a way to bring Elon Musk on board, it may have found a new market to disrupt. The Tesla iCar? Probably no chance of it happening, but I can still dream, can’t I?

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Tesla: A Follow up

My post on Tesla must have touched some nerves because I got more than my usual share of backlash from Tesla bulls. While some of it was just vitriol, many contained interesting counter arguments to mine. I thought it  would be useful to play devil’s advocate and present the case for being bullish on Tesla. I have to tell you that I was not able to convince myself but I may convince you.

Before I make the case for Tesla bulls, I would like to be clear on two points. First, I have no economic or emotional stake in the outcome of the valuation. I don't have a short position on the stock, and don’t plan to, and I have never owned Tesla and don’t regret missing out on the run-up either. Second, notwithstanding the hyperbole that has prefaced some of the press descriptions of my post, I don’t consider myself a valuation guru, expert or prognosticator.  If you are bullish on Tesla, I don’t view you as a sucker or a dunce and I can think of at least three justifications for your bullishness. 

A. Tesla has viable paths to higher value: In presenting my estimate of value for Tesla, I thought I was fairly explicit that it was “my” valuation and not “the” valuation of Tesla. One reason I posted my spreadsheet and left it open, for you the change, is because I understand that there are and always will be differences of opinion on the future of a company, especially one as explosive as Tesla. As I see it there are three possible paths to a value higher than the current price. 

1. The disruptor: It is possible that Tesla is one of those rare companies that disrupts an entire business and changes the definition of what comprises success. Just as Amazon upended the retail business and Apple the smart phone business in the last decade, it is possible that Tesla will create a new paradigm for a successful automobile company: a company that generates Ford-like revenues with Porsche-like margins. (My valuation for Tesla, the disruptor)
2. The power train/battery master: I may have misclassified Tesla as an automobile company and that it’s real innovations are in the power train and battery technology that will make electric cars viable. Ted Lim, one of the commenters on my Tesla post brings a great deal more knowledge than I do to this possibility and he points out the potential for Tesla to become the supplier  to other automakers making electric cars. The potential market for batteries and other original equipment may be smaller than for cars but the margins may be better. (My valuation for Tesla, the OEM company)
3. The "first mover": If Tesla is more technology than automobile company, there is the possibility that if it can establish itself as the leader in the business, there may be a tipping point, where size feeds itself. In practical terms, you are arguing that if Tesla charging and service stations are more extensive than the competitors, buyers of electric cars will be more likely to buy Teslas, thus making it the "electric car" company. (My valuation for Tesla, the network winner).

While I view these paths as narrow and difficult to sustain, I can see why others have a different point of view. There is one note of caution I would add about profitability. Some of you have pointed out that Tesla already has a 25% profit margin and that my assumption that it will generate a pre-tax margin of 12.5% is therefore way too pessimistic. There are two reasons to not get carried away with the current margin. The first is that margin that Tesla is reporting is a gross profit margin, which is significantly higher than an operating margin or a net margin; there is many a cost between the gross and the net. The second is that having a high gross margin, when you are selling relatively few cars at a high price is easier to do than maintaining that margin as you scale up. 

2. Tesla is a pricing game, not a value proposition: When stocks are up four fold or five fold, as Tesla has over the last year, they attract a different class of investors and what happens to the stock price may be more a reflection of what I call the pricing game, rather than underlying value. In two earlier posts, one after the Facebook IPO and one early this year on Apple, and argued that the pricing game is characterized by two features. The first is the ebb and flow of momentum will cause prices to move with investor mood shifts; remember how quickly the momentum game shifted against Apple in September 2012. The second is the supremacy of “incremental information”, where small pieces of news, that have little effect on long term value, have an outsized effect on price. Thus, the story that Elon Musk (who has been masterful at directing the price game to Tesla’s benefit) will be driving across the country in a Tesla S (to show that the car has the range to do so) will get news coverage and may affect the stock price. While I am a believer in long term investing based on value, I have a great deal of respect for the pricing game and recognize the dangers of getting in the way of momentum, at least in the near term. I also know that there are others who are far better than I at playing this game and don’t begrudge them their profits. Thus, if you have been playing this game with Tesla for the last year, you not only have the profits to show for it but also my respect. 

3. There may be a “strategic” buyer for Tesla: This may be cynical of me, but I think of strategic buyers as buyers who first decide that they absolutely have to buy a company and then come up with a price to make that a reality. Since the decision to buy is made before the price is set, it should come as no surprise that strategic buyers tend to pay too much. In the context of Tesla, it is obvious that every large automobile company wants to be the winner in the "electric car" race and will invest large amounts to succeed. While Toyota, Daimler and Ford may all be trying to do this internally, at the moment, history also tells us that patience is not a strong suit in most corporate boardrooms and that one of these companies will probably feel the urge to move faster and spend more. At a market cap of $20 billion, Tesla may seem to be too large a target but as I noted in a series of posts last year, good sense seems to go out of the window in the acquisition process, and more so with large acquisitions than small ones. If Tesla is acquired, you can rest assured that Mr. Musk will extract a significant premium over the market price, even if that price itself is substantially higher than value, and that the acquiring company (and its bankers) will come up with nice buzzwords (control, synergy) to explain it away. 

I hope this post does not come through as defensive. I stand behind my judgment of value for Tesla in the my last post, but all I would take out of that valuation is that I would not buy Tesla at today’s price. Given my fear of getting whipsawed in the momentum game, I would not sell short either. It was not meant to be investment advice.  I am a firm believer that investors have to take responsibility for their own choices and I will respect yours. Thus, if you are a long-term investor in Tesla, because you believe that there are viable pathways to a value higher than the price, I understand your motives. If you are a trader who is playing the pricing game with the stock, I can tell you that I wish I could play that game as well as you do, but I stink at it. So, I won't even try. In closing, though, if you are a Tesla bull and you feel threatened by a blog post from me, I think you may be a lot less secure in your bullishness than you think. 

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Valuation of the week 1: A Tesla Test

I taught the first session of my valuation class, that I previewed in my last post, today. As part of that class, I do what I call a “valuation of the week”, where I pick a company and value it and then post both my valuation (with the spreadsheet and the raw data that I used) and a shared Google spreadsheet for anyone who wants to take my valuation and make it their own (by changing the assumptions). I do this for two reasons. First, I believe that you learn valuation by valuing real companies in real time, not by talking about valuation or reading about it. Second, from a purely selfish standpoint, I pick the companies that I find interesting as potential investments or as real world case studies for my valuations of the week. I find the “crowd valuation” that emerges from this process to be useful in reassessing my own valuations.

As my first valuation of the week, I picked Tesla, for three reasons. First, as a technology company in an otherwise capital-intensive, mature business (the automobile manufacturing business), it stands out. Second, the company has a charismatic CEO, Elon Musk, an ambitious man (and I don’t mean that in a negative sense) with a great deal of imagination. Third,  the stock has taken off in the last year, up more than 500%, fueled by both positive news on the product front as well as on the financial front (increasing revenues, declining losses, paying down of debt). 

At its current stock price of $168.76/share, the market capitalization for the company is more than $20 billion. The question for investors, both in and out of the stock, is not whether the company was a good investment over the last year (of course, it was) but whether it is a good investment today. You can download the most recent annual and quarterly reports for the company.

Using the standard metrics, the company seems  over valued. With revenues of $1.33 billion and an operating loss of -$217 million over the last twelve months, it seems absurd to attach a value of more than $20 billion to the company. At close to 15.4 times revenues, Tesla is being valued more like a young technology company than an automobile company. However, these standard metrics are also often misleading with young companies, since value should be driven not by revenues and earnings today but by expectations for these values in the future.

Expected Revenues

For Tesla to be able to deliver value as a company, it is clear that it has to scale up revenues. On the good news front, the company has had a good year, with the revenues in the first six months of 2013 of $956 million representing a surge from revenues of $41 million in the first six months of 2012. While growth will get more difficult as the company continues to become larger, the question of how difficult cannot be answered until we define the potential market for the company. If we define it narrowly as electric/hybrid cars, the market is small (even though it is growing) and the potential revenues will have to reflect that. If we define it more broadly as the automobile market, the market is a huge one and Tesla’s potential revenue expands accordingly. 

Since the line between electric, hybrid and conventional automobiles is a fuzzy one, which will get fuzzier over time, I will take the view (optimistic, perhaps) that Tesla is an automobile company that happens to specialize in electric cars and measure its potential revenues by looking at the biggest automobile companies today. 

Based on revenues, the biggest companies are those that offer the full range (from luxury to mass market) of automobiles. It is true that BMW and Daimler make the top ten list, but they sell far more than just luxury cars. In valuing Tesla, I am going to assume (and I am sure that some of you will disagree) that success will bring them revenues close to those delivered by a company like Audi ($64 billion). While it is conceivable that Tesla’s revenues could approach those of the auto giants ($100 billion plus), I think the revenue growth required to get to those levels would be incompatible with the high operating margins that I will be assuming for Tesla. Assuming that Tesla stays making just electric cars, this forecast is an optimistic one, insofar as it assumes a rapid expansion in the electric car portion of the automobile market.

Profitability

The second piece of the puzzle in Tesla becoming a valuable company is that it has to become profitable. Based on the reported loss of $216.72 million over the last twelve months, the pre-tax operating margin for the company is -16.31%. It is true that this paints too dire a picture of the company because the company did spend $306 million in R&D over the same twelve month period. Assuming a three-year lag, on average, between R&D expenditures and commercial payoff, and capitalizing R&D does reduce the operating loss to about -$21.86 million (resulting in an after-tax operating margin of -1.64%).

To get a sense of what the Tesla's operating margin will be, assuming it makes it as a successful company, I estimated the pre-tax operating margins of all publicly traded automobile companies globally, dividing the operating income from the most recent 12 months by the revenues over that period for each company. Since automobile companies have volatile earnings, I also computed a normalized pre-ta operating margin for each company by looking at the aggregate operating income over the last decade, as a percentage of aggregate revenues over that period. The distribution of the both measures of operating margin (the 2013 value and the average from 2003-2012) is shown below:

Note that the sector has low pre-tax operating margins, with the median value of less than 5%. Companies at the 75% percentile generate margins of between 7.5% and 8.5% and there are a few companies that generate double digit margins.  One of the outliers is Porsche which reported a pre-tax operating margin of close to 16% in 2013, though its ten-year aggregate margin is closer to 10%. You can download the dataset that includes the key numbers for all auto companies by clicking here.

For Tesla, we will assume that its focus will continue to be on high-end automobiles and that is margins will converge towards the higher end of the spectrum. In fact, I am assuming that the technological and innovative component that sets Tesla apart will allow it to deliver a pre-tax operating margin of 12.50% in steady state, putting it in the 95th percentile of auto companies (and closer to the margin for technology companies). I will assume that the margin improvements occur over time, with the biggest  improvements happening in the near years. The figure below captures the forecasted operating income and margin, by year, in my valuation of Tesla:

Based on my estimates, Tesla will generate more than $8 billion in operating income by year 10, making it more profitable than all but three other automobile companies today (Toyota, Volkswagen and BMW). 

Investment Requirements

Growing revenues roughly sixty fold and improving operating margins to match the most profitable companies in the sector will require reinvestment. Some of it will take the form of additional R&D, as Tesla tries to keep its competitors at bay, and some of it will have to be in more conventional assembly lines and factories, as production gets ramped up. Over time, I believe that the latter component will come to dominate the former.

In my forecasts, I have assumed that Tesla will have to invest about a dollar in capital (in either R&D or plant/equipment) for every additional $1.41 in revenues. That matches the industry average of the sales to capital ratio of 1.41 for US companies. Since the sales to capital ratio for technology companies is higher (2.66), it is possible that I am over estimating Tesla's reinvestment in the early years. However, the return on invested capital that I obtain for Tesla in steady state (in year 10), based on my estimates of operating income and invested capital, is 11.27%, putting it again at the top decile of automobile companies.

Risk

Tesla is undoubtedly a risky investment and there are three components of risk that I attempted to incorporate in the valuation:

a. Business/ Operating risk: Tesla is exposed to substantial business risk, some coming from macro economic sources (the strength of the economy, inflation, interest rates), some resulting from technological shifts (the winning technology in the electric/hybrid auto business is still to be determined) and still more emanating from the sector (with every major automobile company staking out its claim on this segment of the business). To capture the risk, I assumed that Tesla, as it stands now, exposes investors to a mix of automobile business risk and technology business risk. While I assumed a 60% auto/40% technology mix in arriving at a cost of capital of 10.03%, the value per share that I obtain is not very sensitive to this assumption:

Treating Tesla as a purely automobile company increases its value to about $74.73, whereas treating it as a technology company lowers the value per share to $60.84.

b. Geographic risk: While it is likely that as Tesla grows, it will have to look to emerging and more risky markets, I will assume that its risk exposure for the next decade will come primarily from mature markets, allowing me to use my current estimate of the equity risk premium for the US of 5.8% for the cost of equity/capital computations. 

c. Truncation risk: Tesla, in spite of its lofty market capitalization and recent successes, is still a young, money-losing company. A large shock to its business (from a legal setback, a recession or a sector-wide slowdown) could put the company's survival at risk. While that risk has declined substantially over the last two or three years, I think that it still exists and will attach a probability of 10% to its occurrence. If the company does fail, I will also assume that it will lose a significant portion of its value in a distress sale (receiving only 50% of estimated value).

Loose Ends
As with any young company, there are loose ends to tie up that affect value. In particular, I would point to the following:

a. Subsidized debt: Tesla was the beneficiary of subsidized loans from the DOE, amounting to roughly $465 million. While this loan loomed large two years ago, when Tesla was a smaller company with more default risk, it has faded in importance partly because of Tesla's success (and the resulting access to capital markets). Since Tesla has paid down the loan, it no longer has any effect on value.

b. Net Operating Loss carry forward: At the end of 2012, Tesla had a net operating loss of just over a billion that it is carrying forward. I used the NOL to shelter income from taxes in the early forecast years, pushing up cash flows in those years. As a consequence, Tesla's income is sheltered from taxes for the first six years of forecasts.

c. Management/Employee Options: Of larger import are the management/employee options that Tesla has been generous in granting in the last few years. As of the most recent 10K, the company had approximately 25 million options outstanding, with an average strike price of $21.20 and 7 years left to expiration. Since there only 121.45 million shares outstanding, the value of these deep in-the-money, long term options represents a significant drag on value.

The Bottom line

The ingredients that make a young, money-losing company into a valuable, mature company are no secret: small revenues have to become big revenues, operating losses have to turn to profits, there has to be enough reinvestment (but not too much) to make these changes and the risk has to subside. I am assuming all of these at Tesla but my estimated value per share of $67.12 is well below the market price of $168.76. You can download my valuation spreadsheet by clicking here.

Is the value sensitive to my assumptions? Of course, and especially because Tesla is a young company in transition. In fact, replacing my point estimates for the input variables (revenue growth, target operating margin, sales/capital, cost of capital) with distributions yields a distribution of value for Tesla that reflects my uncertainty about the future:

Note that there are scenarios where the value per share exceeds the current market price ($168.76), but I would add two cautionary notes. First, at least based on my estimates, the probability that the value exceeds the price is small (less than 10%) Second, the combination of outcomes (high revenue growth, high margins and low risk)  that would yield these high values are difficult to pull off. 

You can accuse me of being too pessimistic in my assumptions, but the narrative that underlies my valuation is an optimistic one. I am assuming that Tesla will grow to be as large as Audi, while delivering operating margins closer to Porsche's. Even with these assumptions, I cannot see a rationale for buying the company at today's market price but that is just my personal judgment. You are welcome to disagree. In fact, if you download my valuation and change the key assumptions, please take a minute to report your estimate of value per share in this Google shared spreadsheet. Let's see how the crowd valuation plays out!

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MOOCs and Books: Spanning the Digital Divide

As those of you who have followed my blog for awhile know, I post just before the start of a new semester about my upcoming classes and ways in which you can, if you so desire, be part of the experience.  In just under a week, on September 4, I will start the fifty first iteration of my valuation class to the second year MBAs at the Stern School of Business at New York University.  I am just as excited today, as I was when I taught my first version of this class in the 1980s, and I have learned and continue to learn about valuation, each time I teach this class.

Looking back, though, I am struck by both how little and how much technology has changed my classes over the last three decades. The place where there has been the least change is in the classroom, where, as an old fashioned lecturer, my requirements have remained constant: a podium (though I hardly ever stand behind one), a working microphone and a willing/curious audience. I still prepare for classes, exactly the way I did for my very first class, running through the lecture in my head and getting my narrative in place. The slides I use may look slightly more polished than the hand written slides I used twenty five years ago and the projectors may be brighter & sleeker, but they remain props that I can live without. It is true that I have to compete for the attention of my stiudents against more powerful distractions (as tablets, smartphones and computers stay propped open), but that is a challenge I relish (and sometimes lose).  

So, what has technology changed? First, it has given me richer ways of explaining the nuts and bolts of number crunching to those who are interested. Last semester, I put a series of webcasts on valuation/corporate finance practice (from creating trailing 12-month financials, converting leases to debt, computing implied equity risk premiums). Second, it has allowed me to roam the world without leaving the confines of my office. Today, I used Skype Premium to give a two-hour live talk on teaching to a group of freshly minted doctoral students in Hyderbad, India, where they were able to see me (and my presentation) and interact. Third, it has allowed me to package the classroom experience and offer it to a much wider audience. This semester, as in the last few, I will be putting my valuation class online, with nothing held back. In the 26 sessions, starting September 4 and ending December 13, I will try to package and present through everything I know or have learned about valuation, while also revealing to you the great deal that I have left to learn. The class is meant for second year MBAs but if you have the basics of accounting, like working in the numbers and are willing to put in the time, you should not find it too steep a climb. If you so desire, you can watch every lecture, review every slide, do every exam/project and even read every email I send the class. There are three forums you can use:

My site: http://people.stern.nyu.edu/adamodar/New_Home_Page/webcasteqfall13.htm 

Entry requirements: None. There should be no password required to watch the webcasts or download material. 

Description: If you have a computer and a decent broadband connection, you can use the link above to access all of the resources that my regular class has access to. The slides are posted at the top of the page (and are downloadable) and the sessions will be posted sequentially as I teach them. You can watch them in one of three ways:

1. If you don't want large video files (125-200 MB) inhabiting your computer, you can stream them from the NYU server. (Warning: The files are big and can hang up, if your connection is slow).
2. If you don't mind downloading the files on to your computer, you can download the video file (usually in mp3 format) and watch it either in your browser or later on your media player of choice. 
3. If you prefer just an audio file, you can download the lecture in just audio format and then use the slides that you have downloaded to supplement the lectures.

With each session, I will list (and you can download) the slides that I used for the session, the pre-class test that I usually start each session with and a post-class test that you can take, if you want to see if you "get" the material from the session.

Lore: http://lore.com

Entry requirements: Once on the site, click on Join your course, and enter the code DMR44Z. It will let you audit the class.

Description: Lore is an online education company that I have used for more than two years now which marshals what is on my website into more bite-sized and organized pieces. As with the website, you will be able to watch the lectures through Lore and download the slides. One advantage that Lore has is that is has a discussion board where you can can post questions (or answer them) and articles/news for discussion.

iTunes U: https://itunesu.itunes.apple.com/audit/COJN7B8T55 (Link works only from Apple device, not computer).

Entry requirements: An Apple iPad or iPhone with the iTunes U app (free) installed, An Android tablet/phone with the Tunesviewer app (free). First, download the iTunes U app on to your device. Then, click on the link above from your device. Alternative, click on Catalog, and then click on the ENROLL button at the bottom of the Catalog page and enter J7R-DK5-BM3 when prompted.

Description: This is the latest addition to my online choices and it has the smoothest interface. The lectures open up on your iPad and the lecture notes and tests can be viewed on the device as well. The best (and worst) feature of the iTunes U version is that it sends you a notification when something is added to the class; this can of course be irritating and you can turn it off.

I know that some of you are wondering why I am not using Udacity, Coursera or EdX to put my lectures online, but there are two impediments. The first is that will require agreement at the university level, which I cannot (and have no desire to) force. The second is that these entities have their own long term interests to think about (which I respect) but those interests may not be congruent with yours and mine.

I know that some of you have started on my class, in earlier semesters, with the intent of finishing but life has got in the way. If you feel up to it, give it another shot and see if you can get a little further this time. Remember also that while the classes will be posted as they occur, the webcasts and material will stay online for a year and you can catch up over time. In fact, for those of you who prefer to see the complete packaged version of the entire class, my classes on corporate finance and valuation from the spring are on iTunes U as well in archived form:
Archived Corporate Finance class (Spring 2013)
Archived Valuation class (Spring 2013)

In my other avatar, I like writing about what I teach, and just as technology is delivering change (often disruptive) to the education business, it is starting to make itself felt in the publishing business. A few months ago, I finished my second edition of one of my books on investments (Investment Philosophies) and as I readied the e-Book version, I realized how little I was using the power of technology, since the eBook was nothing more than the onscreen version of my physical book. Consequently, my publisher (John Wiley & Sons), Symynd (a company that carried my valuation class online last semester) and I got together a few months ago on new project, where we tried to expand the digital reach for the book by combining it with the key aspects of an online class. Since I have always wanted to teach the investment philosophies class (and have never had a chance to do so), I was on board, and created 38 webcasts (about 15 minutes apiece), tied to chapters in the book. The bundled product, containing the book, webcasts, slides and post-class exercises, is now available on Symynd's website. The book/course costs $75, but you can get it for $45 until September 16, 2013, if you enter the promo code PROMO75.  Since the book alone costs about the same, you can think of the course as being icing on the cake for free. In the next few months, Symynd/Wiley/I are planning to do the same with my applied corporate finance and valuation books. If you are budget constrained and are unable to spend the $45, I have created both an online version and an iTunes U course around the webcasts, slides and exercises. It is not as polished as the Wiley/Symynd version and it does not come with the book, but it does provide the essence of the class.

I consider myself lucky to be in two businesses, education and publishing, that are in the midst of disruptive change. For those in both businesses who are defenders of the status quo, the change that is coming will threaten many long standing (and indefensible) privileges including tenure, bundling and lack of accountability. For the rest of the world, though, who have have had to shell out outlandish amounts of money as college tuition and to pay absurd sums for "new" editions of college text books, I hope that the change delivers much needed good news (and power).

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Market Mood Swings: Facebook Euphoria

Facebook's stock price briefly hit $38, its IPO price, just before today's opening bell. In the 15 months since it went public, the stock had certainly had its ups and downs as evidenced in this graph:

As some of you who have tracked my blog posts over the last couple of years know, I have tried to make sense of Facebook's value and how the market has been pricing it. Given today's news, I thought it would be useful to go back first to these earlier posts and then do a fresh valuation of the company, with updated information.

The lead up to the IPO

Facebook had perhaps the most elaborate run-up to an IPO in stock market history, with billions of dollars in transactions in the private share market, stories aplenty in the news media and even a hit movie about its founders. My first attempt at valuing Facebook was in February 2012, when I attached a value of $68 billion to its equity, with extremely generous assumptions on revenue growth and margins. In estimating this value, I assumed that Facebook would have a revenue growth path very similar to Google's, while sustaining operating margins like Apple. 

As the initial public offering drew nearer, I grew increasingly wary about the offering for two reasons. The first was the sense that many investors, especially institutional, seemed to think that the Facebook IPO was an absolute no-lose proposition, no matter what the offering price was, since momentum would carry the stock higher. In this post, from February 2012, I cautioned investors from buying into this proposition. The second was that the company and its bankers seemed to assume that they could set the terms for the offering and that the market could go along. In my experience, those who believe that they have power over markets realize otherwise, sooner rather than later.

The IPO

On May 17, 2012, just after the lead investment banks set the offering price at $38/share and the day before the offering date, I did my final pre-IPO valuation and estimated a value per share of about $25/share. While you can get the excel spreadsheet containing the valuation in this post, I think this picture better illustrates the assumptions and linkages that went into my estimate of value:

The actual offering date is now part of market lore, from the technical problems that NASDAQ had in getting the trading started to the substantial support that the investment banks had to offer to keep the price from collapsing. After an initial spurt in the price to $42, the stock ended the day at $38.23 a share.

Once the price support faded, the stock price retreated in the weeks after the IPO to drop below $30 in June 2012. In a post after the IPO, I argued that the market reaction to the IPO was just desserts for the arrogance and hubris of both investment bankers and the company in the lead up to the IPO. 

The Early Returns

In the months after the IPO, Facebook faced a mountain of troubles, some of its own doing and some reflecting the costs of going public. The IPO failure colored investors' views of the company and its management, leading them to put the worst possible spin on every action and occurrence at the company. At the same time, the IPO also exposed the company to significant costs, especially as the costs of stock-based compensation were recognized, leading to a drop in operating income.  The nadir for the stock was the quarterly earnings report about a year ago, when the company reported sagging revenue growth and much lower margins. The momentum game turned fully against the company, with many of the analysts and institutional investors who had been cheerleaders in the pre-IPO days arguing that the stock was a "sell".

On August 20, 2012, Facebook had dropped below $20/share and I made an argument that the market had over reacted to news and that the earnings reports were not as catastrophic as they were perceived to be. I also argued that investors were being distracted by side stories about expiring lock ups and mobile mashups. In fact, my estimate of value in August 2012 was $23.94, just a couple of dollars below my estimate on the day before the IPO. At the end of the post, I noted that I had a limit buy order at $18/share on the stock and that notwithstanding my concerns about corporate governance in the company and the near term effects of momentum, it looked like a decent buy. 

Now, a confession. I had never, ever bought a stock on the date that it hit its absolute low, until my limit order for Facebook got fulfilled at the start of trading on September 4, 2012. The stock hit its low of $17.58 that day and, even with setbacks along the way, it has not looked back since. I would love to claim timing precision but it was absolute luck, and I would rather be lucky than good.

Learning from Earnings: Updating the Facebook valuation

If the first two earnings reports were viewed as negative surprises, they did bring expectations down for the company and the company has delivered positive earnings reports in its last three earnings reports. While it is easy to get lost in the minutia of these reports, here are the news stories that I see embedded across the earnings reports:

1. Revenue growth continues to be strong: Revenues at the company over the first two quarters of the current financial year have been about 46% higher than revenues in the first two quarters of the last financial year, just above the expected growth rate of 40% used in the IPO valuation.
2. Operating margins remain high: Operating margins declined last year, primarily because of the expensing of stock-based compensation from pre-IPO days. That load has been lifted in this fiscal year and the operating margin over the last four quarters is about 30%, if R&D is expensed, and closer to 40%, if it is capitalized.
3. Facebook remains for the most part an "advertising" company: While Facebook has made attempts to broaden its revenue base and product mix, it remains dependent upon advertising for 84% of its revenues in the last four quarters, not significantly different from pre-IPO days.
4. Facebook seems to have broken the "mobile media" code: It is true that the last few earnings reports have included good news on the mobile media front, with Facebook showing the capacity to deliver, but am afraid that I don't share the euphoria with which some investors have greeted this news. Don't get me wrong! Being successful in mobile media is critical to Facebook's success but the revenues that I (and others) have projected for Facebook last year assume that success. So, the good news in the mobile media market keeps them on the forecasted revenue path, but failure would have been devastating. 
5. Management has matured: If there is good news that came out of the botched IPO, it is that the managers at Facebook (from the top down) seem to have learned two critical lessons. First, they no longer seem to be taking markets for granted and are taking the effort to explain not only what they are doing but why. Second, they seem to have realized that analysts and bankers don't lead the market, but follow it. Nevertheless, the company remains a corporate governance nightmare, with voting rights concentrated in Mark Zuckerberg's hands, but at least for the moment, he seems to be behaving more like a benevolent monarch than a malevolent dictator. 

Incorporating the information in the last earnings report, I tweaked my valuation of Facebook and the word "tweaked" is used intentionally. None of the big news in the earnings reports represents significant departures from assumptions made in earlier valuation. The good news in revenue growth and operating margins was already being assumed and the fact that Facebook remains an advertising driven company puts limits on how big revenues can get. My estimate of value per share for Facebook has risen from $24/share at the depths of despair last August to about $27.65/share today (July 31, 2013). As always, you are welcome to download the spreadsheet and replace my assumptions with yours.

So, what now?

The old "buy and hold" advice, where we are told to buy good companies and leave them in our portfolios for posterity, makes little sense with growth companies, where markets often over shoot and under shoot. Last August, it was my belief that markets were over reacting to limited information in an earnings report from a young company and pushing its price down too much. Today, I believe that the markets are over reacting again to limited news from an earnings report and pushing the price up too much. As an investor who was lucky enough to buy last August, because the stock was trading below my estimate of its intrinsic value, I have to be consistent and sell, if the opposite holds now. The only pragmatic consideration that I have relates to taxes, since I will save substantially, if I can wait until September 4 to sell (when my gains will become long term capital gains).

So, what if you don't own the stock? Should you sell short? I personally would not, since it is entirely possible that the momentum game that was so firmly against Facebook last year might work in the other direction now. There may be investors who will be drawn in to the stock if it crests the $38 IPO price, though there is really no economic or value significance around the number. 

One final note. Even though I am selling Facebook, I will continue to follow the company. After all, the company may very well fall out of favor with investors in a few months and be back on my buy list. Bipolar markets are sometimes an intrinsic value investors best friend.

My previous posts on Facebook
The IPO of the decade: My valuation of Facebook (February 16, 2012)
Facebook: Playing the IPO pop game (February 26, 2012)
Facebook and Field of Dreams: Hoodies, Hubris and Hoopla (May 17, 2012)
Facebook: Sowing the wind, reaping the whirlwind (May 23, 2012)
Facebook face plant: Time to friend the company (August 20, 2012)
Much ado about liquidity: Lockup Expirations and Stock Prices (November 19, 2012)

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Market Multiples: Global Comparison and Analysis

In my last two posts, I looked first at measures of country risk, both from a default risk and an equity market perspective, and then at stock pricing, using earnings and book value multiples, across developed and emerging markets. In summary, the conclusion that I drew was that the shift away from emerging markets in the last six months may be obscuring a much larger shift towards convergence between emerging and developed markets over the last decade. Thus, we can debate whether this convergence is rational or overdone, but it is quite clear that stock markets around the world have more in common now than they are different. Having said this, it is worth noting that the developed and emerging market categories that I used in the last post, which were based on geographic location, may no longer reflect the reality that there is vastly more diversity within each region than there used to be. In this post, I intend to look at the pricing of stocks, by country, not only to illustrate this diversity but also to look for mis pricing, at a country level, around the globe.

PE Ratios around the globe

The price earnings ratio, notwithstanding its volatility and measurement weaknesses, remains among the most widely used tools in investing. In fact, some global investors still compare PE ratios across countries and often direct their money towards countries with low PE ratios, on the presumption that this must indicate "cheapness".

To put this approach into practice, I first computed PE ratios in June 2013, by country. During the computation, I noted a couple of phenomena, which while unsurprising, are still worth emphasizing. The first is that almost 60% of all companies globally have negative earnings and PE ratios are thus not meaningful for these companies. The second is that there are significant outliers, with a few companies with exceptionally high PE ratios (usually because earnings have dropped to close to zero) pulling the  averages to high numbers, especially in countries with relatively few companies. To get a more representative value, I computed the PE ratio based on aggregate values for market capitalization and net income. Put simply, I summed up the market capitalization of all the companies in a market and divided by the total net income of all companies in a market. This aggregate value is not as sensitive to outliers and reflects more closely a weighted average of the companies in the market, with values representing the weights. 

The heat map below allows you to compare PE ratios across countries, and within regions.

Note that the countries with the lowest PE ratios (in yellow and orange) are also among the world's riskiest (a large swath of Africa, Venezuela (Latin America) and Eastern Europe). Put differently, these countries look cheap, but they have good reasons to be cheap. The bulk of developed markets have PE ratios between 10 and 15, with the weighted PE ratio at 10.49 for Germany, 12.81 for Japan and 14.27 for the US. Surprisingly, Mexico and Chile have the highest weighted PE ratios, with Mexico at 18.04 and Chile at 18.64. There are also large sections of the world where PE ratios cannot be computed, either because earnings information is not available or because earnings are negative.

If most of the low PE countries are high risk and the bulk of the high PE countries are low risk, we have to use more finesse in looking for cheap and expensive markets. In fact, a cheap market would offer a combination of a low PE and low risk and an expensive market would be one with high PE and high risk. To look for those mismatches, I combined the PE ratio dataset with the equity risk premiums estimated in the prior blog post and generated a list of the ten countries with the highest and lowest PE ratios, with accompanying equity risk premiums. 

Of the ten countries with the lowest PE ratios, only two (Kazakhstan and Azerbaijan) had equity risk premiums less than 10% and I cam not tempted to invest in either country (given their dependence on commodity prices and political risk profiles). There are more interesting countries on the highest PE list, though a couple reflect commodity price volatility; the drop in copper prices, for instance, has hit Chilean company earnings harder than it has market capitalizations. 

Price to Book Ratios

The price to book ratio is often a less volatile and more reliable measure of pricing in a market. While accounting choices can affect book value, the effects of these choices are more muted than on earnings. As with PE ratios, I computed both the average price to book ratios and price to book ratios based upon aggregate market capitalization and book equity and decided to use the latter as the indicator of overall pricing. The map below provides comparisons of the aggregate price to book ratio across the globe:

Unlike PE ratios, there seems to be little relationship between the dispersion of price to book ratios across the globe and country risk. Some of the highest price to book ratios are in the riskiest countries: Namibia, Indonesia and Venezuela all have price to book ratios that exceed 2.50 and are all high risk countries.

As with PE ratios, a naive strategy of directing your money to the countries with the lowest price to book ratios may be dangerous, since these low multiples of book value can be explained by low returns on equity. The following is a list of the ten countries with the highest and lowest price to book ratios:

Note that the countries with the highest price to book ratios also tend to have very high returns on equity, whereas some of the countries on the lowest price to book ratios have negative or low returns on equity. There are some mismatches, especially on the low PBV list, with Zimbabwe, Lebanon and Russia joining Kazakhstan and Azerbaijan as markets with low price to book ratios and high returns on equity. In addition to all the caveats about hidden (and not so hidden) risks, it is also worth noting that some of these markets have only a handful of listings and no or low liquidity.

Enterprise Value to EBITDA multiples

Some investors and analysts take issue with equity multiples, arguing that they do not account for overall value and leverage. Consequently, I estimated enterprise value to EBITDA multiples for individual countries, using both simple averages and aggregated values. The resulting global map of EV to EBITDA multiples is below:

This map more closely corresponds to the PE map, with riskier countries having lower EV to EBITDA multiples (with Mongolia being an exception). The median value across the globe is 8.03, with the United States (8.45), Australia (8.59), India (9.48) and China (9.99) trading above the value and much of Western Europe trading below.

Just as I balanced PE ratios against risk and PBV against ROE, I brought in return on invested capital (ROIC) into the comparison of EV/EBITDA multiples, on the assumption that higher ROIC is more likely to accompany higher EV/EBITDA multiples. Again, the list of countries with the highest and lowest EV/EBITDA multiples, with ROIC for each, is in the list below:

Unlike with equity multiples, the relationship between ROIC and EV/EBITDA is in the inverse of expectations, with countries with the higher (lower) returns on invested capital having the lowest (highest) EV/EBITDA multiples.

Wrapping up

At the end of the comparisons of equity and enterprise value multiples, I must confess that I feel little inclination to make abrupt asset allocation judgments based upon any of these multiples. It is true that some markets seem to offer better risk and return trade offs than others, but these markets seem to come with warning labels (about political or commodity price risk). It is also possible that I am missing some hidden patterns here and you are welcome to download the dataset containing my estimates of both average and aggregate values, by country. 

Notwithstanding the noise in the numbers, I am glad that I was able to look at the numbers across countries. I feel a little more informed about how stocks are being priced across the globe and how investors are pricing in the most extraordinary and unusual risks in some markets. I also realize how much I have left to learn about how stocks are priced in countries with non-traditional risks and will keep working at filling in the gaps in my knowledge.

1. Rediscovering risk in emerging markets: A country risk premium update
2. Developed versus Emerging Markets: Convergence or Divergence? 
3. Market Multiples: Global Comparison and Analysis
4. Global Businesses and Country Risk: Investment Challenges and Opportunities (Still to come)

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Developed versus Emerging Markets: Convergence or Divergence?

In my last post, I looked at country risk first from both a bondholder perspective (with ratings, default spreads and CDS spreads) as well as an equity investor perspective (with my estimates of equity risk premiums by country). While default spreads in sovereign bonds and differences in CDS spreads are explicit and visible to investors, the question of whether equity markets price in differences in equity risk premiums is debatable. In fact, there are quite a few analysts (and academics) who argue that country risk is diversifiable to global investors and hence should not be priced into stocks, though that argument has been undercut by the increasing correlation across equity markets. In this post, I look at the pricing of stocks across different markets to see if there is evidence of differences in country risk, and if so, whether market views of risk have changed over time.

Stock Prices and Risk Premiums

Holding all else constant, stocks that are perceived as riskier should sell for lower prices. That can be illustrated fairly simply using a basic discounted cash flow model. Consider a firm that pays out what it can afford to in dividends and is in stable growth (growing at a rate less than or equal to the economy forever). The value of equity in the firm can be written as:

Rewriting the expected dividends next period as the product of the payout ratio and expected earnings, we get:

    

Now, assume that you are valuing two companies with equivalent growth rates and payout ratios, in US dollars, and that the only difference is that one company is in a developed market and the other is in an emerging market. If investors in the emerging market are demanding a higher equity risk premium, the emerging market company should trade at a lower PE ratio than the developed market company.

So what? A simple test (perhaps even simplistic, since holding growth and payout constant is tough to do) of whether equity risk premiums vary between developed and emerging markets is to compare the multiples at which companies in these markets trade. If emerging markets command higher equity risk premiums, you should expect to see stocks trade at much lower multiples (PE, PBV, EV/EBITDA) in those markets, relative to developed markets, for any given level of growth and profitability.

Market Convergence: The Pricing Story

To examine how developed market and emerging market PE ratios have evolved over time, I computed PE ratios for each company in every market each year from 2004 to 2012, with an update to June 2013. I eliminated any company that had negative earnings and divided the market capitalization at the end of each year by the net income in that year.

I then categorized the companies into developed and emerging markets, using conventional geographical (but perhaps controversial) criteria. I included US, Canada, Western Europe, Scandinavia, Australia, New Zealand and Japan in the developed market group and the rest of the world (Latin America, Asia, Africa, Middle East and Eastern Europe/Russia) in the emerging market group. In sum, there were 36,067 companies in the developed market group and 24,429 companies in the emerging market group. 

I considered various summary statistics (the simple average, a weighted average, an aggregate market cap to earnings) but decided to use the median PE as the best indicator of the typically priced stock in each market. In the figure below, you can see the median PE ratios for developed and emerging market companies by year, from 2004 through June 2013.

Prior to 2006, emerging market PE ratios were about 30% lower than developed market PE ratios, but after almost catching up in 2007, the banking crisis of 2008 caused a drop in emerging market PE ratios, relative to developed markets. In the years since, emerging market companies have clawed their way back and the PE ratio for emerging market companies exceeded that of developed market companies in 2012. The shift away from emerging markets in the first six months of 2013 has put developed companies into the lead again, though the developed market PE premium (over emerging markets) in June 2013 is significantly lower than the premiums commanded in the early part of last decade.

Deconstructing the Convergence

The convergence of PE ratios across the globe is striking, but it is worth noting that it is more attributable to a decline in PE ratios in developed market PE ratios than to a surge in emerging market PE ratios. In fact, this phenomenon is made more explicit if we look at the median price to book ratios across developed and emerging market companies from 2004 to 2013:

The convergence that we see in PE ratios is even more striking when it comes to price to book ratios, but note that the convergence is largely coming from the drop in price to book ratios in developed markets, not from a increase in those ratios of emerging markets.

Reasons for Convergence

The convergence in PE ratios and PBV ratios between developed and emerging markets is confirmed when we look at other multiples (EV/EBITDA, for instance). The question therefore becomes not whether there is convergence, but why the convergence is occurring.  There are at least three possible stories (and perhaps more).

1. Decline in profitability at developed market companies, relative to emerging market companies: It is possible that shifts in global economic power have made developed market companies less profitable than they used to be, thus lowering pricing multiples for these companies. One measure of profitability is the return on equity earned by companies, estimated by dividing net income  by book equity. The median returns on equity for developed market and emerging market companies, each year from 2004 to 2013, are contrasted below:

Note that emerging market companies have had higher returns on equity than developed market companies in every year. While the 2008 crisis has resulted in declines in return on equity across both groups of firms, developed market companies have almost caught up in terms of return on equity with emerging market companies, suggesting that it is not profitability that explains the PE/PBV convergence.

2. Declining differential equity risk premium (between developed and emerging market companies): A second potential explanation is that the differential equity risk premium between developed and emerging markets has decreased over the last few years. There is a fairly simple mechanism for backing out the implied costs of equity and equity risk premiums from the price to book ratios and returns on equity. If we assume firms are collectively in stable growth, the price to book ratio can be written as:

Moving the terms around allows us to restate the equation in terms of cost of equity:

To compute the costs of equity in US dollar terms, we will set the expected growth rate for each year to be equal to the US treasury bond rate in that year and derive the cost of equity for developed and emerging markets in that year. I know that assuming the same growth rate in developed and emerging markets is simplistic, but I will revisit this assumption later.

For instance, take 2004, when the price to book ratio for developed markets was 2.00, the return on equity for developed markets was 10.81% and the US T.Bond rate was 4.22%. The implied cost of equity for developed markets in 2004 is 7.52%:

Implied cost of equity in 2004 (developed) =((.1081-.0422)/2.00) + .0422 = .0752 or 7.52%

In the same year, emerging market companies had a price to book ratio of 1.19, a return on equity of 11.65% and a resulting implied cost of equity of 10.46%:

Implied cost of equity in 2004 (emerging) =((.1165-.0422)/1.19) + .0422 = .1046 or 10.46%

If you accept these estimates, emerging markets had an equity risk premium about 2.94% higher than developed markets:

Differential ERP = 10.46% - 7.52% = 2.94%

I repeated this estimation process for 2005 through 2013 to yield the following:

The last column is striking, as the differential ERP dropped close to zero at the end of 2012 before rebounding a little bit in the middle of 2013. In fact, at the 0.50% level in 2013, it is still well below historical norms.

3. Decline in differential real growth: Now, let's revisit the assumption that I made in the last section that both developed and emerging markets will grow at the same rate (set equal to the US treasury bond rate each year). You can take issue with that assumption, since emerging markets have not only more growth potential but have delivered more real growth that developed markets over the last two decades. If you assume higher growth in emerging markets than developed markets, the table above overstates the equity risk premium for developed markets, while understating the premium for emerging markets. I redid the table setting the growth rate in developed markets at 0.5% below the risk free rate, while allowing the growth rate in emerging markets to be 1% higher than the risk free rate; this results in 1.5% difference in annual real growth rates between the two groups. 

While the differential ERP is higher in every year, with the assumption of higher growth in emerging markets, the trend line remains unchanged with the differential value hitting a low at the end of 2012. Unless you assume a widening of the difference in expected real growth between developed and emerging markets between 2004 and 2012, which would be difficult to justify given the growth in size of emerging markets over that period,  a decrease in differential equity risk premiums seems to be the most likely explanation for the convergence in multiples across markets.

In summary, the shrinking differences in pricing between developed and emerging markets cannot be explained by profitability trends or changes in real growth but can be at least partially explained by narrowing risk differentials between the markets and the globalization of companies.

Implications
The trend lines in profitability, risk and pricing over the last decade are interesting from a macro standpoint but there are three general lessons/implications for investors:

1. Reality check for expectations in emerging markets: For the last two decades, developed market investors have been lured into investing in emerging markets by the promise of higher returns in those markets, though accompanied with the caveat of higher risk. If the last few years are any indication, it is time for investors to adjust expectations for emerging market returns, going forward. Emerging market companies are no longer being priced to generate premium returns, but they are also no longer as risky as they once were (at least relative to developed market companies).
2. Markets can still over shoot: While it is clear that emerging markets have evolved in terms of economic growth, political maturity and risk, it also remains true that there is more risk in these markets than in developed ones. Markets, however, often move in ebbs and flows, under estimating this differential risk in some periods and over estimating it in others. Thus, a reasonable case can be made that markets were being over optimistic about emerging market risks, when they priced stocks to generate roughly the same expected returns in developed and emerging markets at the end of 2012 (see the table in the last section) and that the correction this year is a reversal back to a more reasonable differential premium. For those who believe that the reasonable premium is that observed between 2004 and 2006 (when the average differential in ERP was 2.5% and higher), this would lead to the conclusion that there is far more pain to come in emerging markets. If you believe, as I do, that the norm is closer to that reflected in the average since 2008 (about 1 to 1.5%), the correction is about half way over.
3. Think global, not local: As companies, notwithstanding where they are incorporated, increasingly become global competitors, it can be argued that equity risk premiums will converge across markets, since each market will be composed primarily of global companies exposed to risks around the world. For investors and analysts in developed markets, there is the unsettling reality that emerging market risk is now seeping into their portfolios, even if it is composed purely of domestic companies. For investors and analysts in emerging markets, there has to be the recognition that the automatic discounts that they apply to emerging market company multiples, relative to developed markets, may no longer be appropriate. I will return to this issue in a future post.

1. Rediscovering risk in emerging markets: A country risk premium update
2. Developed versus Emerging Markets: Convergence or Divergence? 
3. Market Multiples: Global Comparison and Analysis
4. Global Businesses and Country Risk: Investment Challenges and Opportunities (Still to come)

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