The "dividend tax" cliff approaches: Implications for stocks

A great deal has been written about the "fiscal cliff" that US taxpayers, investors and companies are faced with at the end of this year. Put simply, all of the tax changes made in 2002 and 2003 expire at that time, and the tax code will, in large part, revert to what it was prior to those changes. I will leave it to others to debate the macro economic implications of going over the cliff but I want to focus on one "segment" of the code that has implications to valuation.

In 2003, the tax code was altered to bring the tax rate on dividend income down to 15%, to match the tax rate on capital gains. That was, in a sense, a revolutionary move, at least for the US, since dividends had been taxed much more heavily than capital gains for much of the previous century. I did write a paper in 2003 about the potential implications of the tax law change for businesses that you can read. In effect, I argued that the tax change would have a positive effect on stock prices, that the effect would be greater for "high" dividend paying stocks than for non-dividend paying stocks and that corporate dividend policy would be altered by the change. Now that there is the possibility that the law will be reversed, it is time to revisit the issue.

Dividends, Expected Returns and Stock Prices: Why taxes matter...

To understand the impact of investor taxes on dividends, let's begin by looking at how  you would price stocks in a world where interest income, dividend income and capital gains are not taxed. Let's assume that the risk free rate is 1.5% and that stocks are collectively paying a dividend yield of 2%. To induce you, as a risk averse investor, to invest in stocks, you would need to be offered a premium (at least on an expected basis) over the risk free rate. Let's assume that you would demand a premium of 4.5%, after personal taxes, to shift from the riskfree asset to risky equities. Thus, you would need to earn a 6% return (1.5%+4.5%), after personal taxes, to invest in stocks. Since this is a world with no taxes, your pre-tax expected return would also by 6%; with a dividend yield of 2%, the expected price appreciation on stocks would have to be 4%.

Now, introduce a uniform tax rate of 15% on interest income, dividend income and capital gains into this world. Since you need to earn 6% after taxes, you would need to earn 7.06% before taxes:

Expected pre-tax return = Expected after-tax return/ (1- Uniform tax rate) = 6%/ (1-.15) = 7.06%

Thus, if stocks continue to pay a 2% dividend, the expected price appreciation would need to 5.06%. The higher required return would mean that stock prices would have to drop, relative to what they were in a world with no taxes. With the existing tax law, we are close to this tax regime (with the only difference being that interest income is taxed at a higher tax rate). This is close to the current tax regime.

Let's now change to law to reflect what the tax rate will be on January 1, 2013, if we do revert back to pre-2003 levels. The tax rate on dividends, for individual investors, will revert back to the ordinary income tax rate. At the margin, for unmarried (married - joint filing) investors generating more than $ 85,650 ($142,700) and  in income, that rate will be close to 35% (counting just Federal taxes and incorporating the additional taxes that the new health care law will impose on dividends and other investment income) and approach 40% for those with income levels exceeding $178,650 ($217,450). The tax rate on long term capital gains will also go up, but only to the 20% rate that prevailed prior to 2003. If companies continue with a dividend yield of 2% and the price appreciation stays at the 5.06%, investors will earn a much lower after-tax return:

After-tax return with pre-2003 tax rates = 2%(1-.40) + 5.06% (1-.20) = 5.25%

If investors risk preferences have not changed, they will have to want to continue to earn 6% after taxes, but the pre-tax return would have to increase to compensate for the higher taxes. In fact, if we assume that the dividend yield stays fixed at 2%, we can solve for the required price appreciation

2% (1-.40) + X (1-.20) = 6%

Solving for X, we get a required pre-tax price appreciation of 6% and a required pre-tax return of 8%. That would translate into a significant drop in stock prices.

Making it real: The dividend cliff and the S&P 500

To make this less abstract, let's work with some real numbers. At the start of every month, I back out the expected return on stocks from the level of the index (S&P 500) and expected cash flows. At the start of September 2012, when the S&P 500 was at 1406.58, I computed an expected return on stocks of 7.30% (yielding an equity risk premium of 5.75% over the risk free rate of 1.55%). This expected return is what investors are demanding on a pre-tax basis on stocks. Since the current dividend yield on the S&P 500 is about 2.01%, the expected price appreciation on a pre-tax basis is 5.29%. Since both dividends and capital gains are taxed at 15%, under the pre-cliff tax law, the post tax return is 6.21%:

After-tax return in September 2012 with current tax law = 2.00% (1-.15) + 5.29% (1-.15) = 6.21%

Now, let's assume that investors will continue to demand this after-tax return in 2013, that the tax laws revert back to pre-2003 levels and that companies continue to maintain a dividend yield of 2.01%:

2.01% (1-.40) + Expected pre-tax price appreciation (1-.20) = 6.21%

The expected pre-tax price appreciation would have to be 6.25% and the required return on a pre-tax basis would have to be 8.26% on the S&P 500, yielding an equity risk premium of 6.71% over the riskfree rate of 1.55%. Holding the cash flows the same and changing the equity risk premium to 6.71% yields a value of 1201.22 for the S&P 500, a drop of about 14.60% in the index from current levels. If you don't agree with the assumptions I have made, not a big deal. I have attached the spreadsheet that I used and you can compute your own estimate.

Differential impact: High dividend versus non-dividend paying stocks

Note, though, that the effect of the reversal in the tax law will not be uniform, since every company does not have a dividend yield of 2%. Companies with high dividend yields, that continue to pay those dividends, will see expected returns increase more and stock prices drop by a more significant margin. In the graph below, I have compute the percentage change in stock prices you can expect in stocks with dividend yields of 0% to 4%.

Note that the stocks with the 4% dividend yield, holding all else constant, will see stock prices drop by 18%,, whereas the stocks with the 0% dividend yield will see a price drop of only 7%.  Again, you can use the spreadsheet and alter my assumptions, if you so desire, and compute the effect on any individual stock.

The Weak Links

This analysis suggests that a sharp correction is ahead for stocks collectively and especially so for high dividend paying stocks. It is, however, based on a set of assumptions about tax law and markets that may not be correct.   So, what are the weakest links in this analysis?
1. There is no chance that the fiscal cliff will become reality: This is not the first time that we have faced the possibility of the tax laws reverting back to pre-2003 levels. At the end of 2011, faced with the possibility, Congress and the administration pushed off the day of reckoning at the last moment. It is possible that faced with the catastrophic consequences of going over the cliff, Congress will find a way to avoid it again, but is it guaranteed? Having seen the political dysfunction at both ends of Pennsylvania Avenue over the last decade, I am not as confident as others may be that common sense will prevail and that the cliff will be avoided.
2. Not all investors pay taxes on investment income: In my analysis, I used the tax rates on wealthy individual investors to make my assessment, but tax rates vary widely across investors. There are two critiques that can be mounted. The first is that about 60-70% of stocks are held by non-individuals: mutual funds, pension funds and corporations and the tax rates that these investors may not be affected (or at least not as much) by the change in the tax law. The second is that companies that pay high dividends attract investors who like those high dividends and it is possible that these investors make less income and face less of a hit from the change in the tax law.  Note, though, that even if we factor in these investors, the basic analysis still holds but the impact will be lightened. In fact, one way to alter the analysis is to take a weighted average tax rate across all investors in the market, which would buffer the impact. The graph below estimates the effect on the market, stocks with a dividend yield of 4% and stocks with a dividend yield of 0% of assuming lower tax rates in the post-cliff period.

3. Investors may already have built in the expectation that tax laws will change into current stock prices: To the extent that the fiscal cliff has been in the news and widely reported, it is possible that the market has already incorporated the possibility of it coming to fruition into stock prices and the expected return. I would have been inclined to believe this if I had seen the equity risk premium climb, and stock prices drop, over the course of the year, but they have not. In fact, we started the year with a much higher equity risk premium of 6.04% and have seen the premium drift down to 5.75%.

4. Companies may change their dividend policy: I did predicate my analysis on companies maintaining their dividends at 2012 levels, even if the tax law changes to tax dividends more highly in 2013. In fact, if companies were completely flexible, they could stop paying dividends and largely nullify the impact of the tax law change. History suggests that this is unlikely. If there is a word that best describes dividends, it is that they are "sticky", i.e.. that companies are reluctant to change dividends and especially to cut them. In fact, the 2003 law did not to lead to a surge in dividends (though a few companies pay special dividends in the immediate aftermath) and I don't think that a reversal of the law will lead to a sudden reassessment of dividend policy.

Bottom line:  I may be overly pessimistic, but the dividend cliff scares me and I am planning for the eventuality that the tax code will change drastically on January 1, 2013. I am and will continue pruning my portfolio, shifting my money from large dividend-paying US stocks to non-dividend paying or low-dividend paying foreign stocks. I won't go overboard and sell short/ buy puts on high dividend paying stocks. After all, the dividend tax effect is one of many forces that will affect equity markets over the next few months and it is possible that one of these effects will drown out the tax effect.

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Inspiration or Insanity? Fed action and Market Reaction

The big news of last week was the Federal Reserve's announcement of QE3, i.e.,  that it would buy $40 billion worth of bonds each month until the economy was back on its feet again. The fact that the commitment was open ended (unlike  QE2 and Operation Twist, the two prior big moves by the Fed during the last three years) and directly tied to stronger employment/economy was viewed as positive by the stock market, which jumped about 2% in the two days after.  I am sure that I am missing some significant piece of the puzzle, but as I watch the news coverage and market reaction, I am reminded of one of my favorite movies, "Groundhog Day".

While we can debate the intent behind the Fed move and whether it would succeed at awakening the economy, I would posit three points (all of which I am sure are debatable):

1. The Fed does not set market interest rates: Much as I would like to buy into the notion that the Fed sets mortgage rates, corporate bond rates and treasury rates, the only interest rate that the Fed actually sets is the Fed Funds rate, the rate at which banks trade balances at the Federal reserve. In fact, if the Fed has as much power over interest rates as we think it has, the US would not have had double digit treasury bond rates in the 1970s.
2. The Fed’s influence on market rates is greater at the short end than at the long end of the spectrum: It is true that the Fed can influence market interest rates through its actions on the Fed Funds rate, with interest rates falling (rising) on signals of a looser (tighter) monetary policy", but that fall or rise is greatest for short term rates. It is also true, in Operation Twist and continuing into QE3, the Fed is pumping billions into the bond market with the intent of keeping longer term rates low. The bottom line though is that influence does not equate control, and the bond market is far too large for even the Fed to turn the tide (if the tide is running against what the Fed would like to do).
3. What the Fed wants to do and what it seeks to accomplish with that action seem at war with each other: If I understand what the Fed is doing, its intent is to keep interest rates low to induce higher real growth (and lower unemployment) in the economy. There is an inherent contradiction between the Fed's action and its objective. If the economy starts growing faster, market interest rates cannot and will not stay low, no matter what the Fed does. Thus, the only way the Fed can keep interest rates low for an extended period is if low interest rates do not translate into a stronger economy.   I would argue that the the Fed's earlier moves in this recession (QE1, QE2 and Operation Twist) make this point for me. Interest rates have stayed low, with mortgage rates and corporate bond rates at historical lows, but they have done so, because the economy has stagnated. 

To address the question of whether the Fed action is good for stock prices/values, I would list three “macro” variables that underlie the valuation of all equities:

1. The risk free rate: The first corner of the triangle is of course the risk free rate, i.e, the rate you would earn as an investor on a guaranteed investment. Holding all else constant, a lower risk free rate should translate into higher equity values. 
2. Equity risk premium: The second corner is the equity risk premium, which is the premium that investors demand for investing in stocks as compensation for exposure to macroeconomic risk, i.e., uncertainty about real economic growth and inflation. Holding all else constant, a lower equity risk premium should translate into higher equity values. 
3. Real Growth: The third corner is real economic growth, with higher real growth, all else held constant, translating into higher equity values.

If you hold real growth and equity risk premiums fixed, and lower interest rate, the values of all financial assets should rise. But “holding all else constant” is easier said than done.  If the risk free rate is low because real growth is expected to be low and/or because investors are fleeing to safe harbors in the face of crisis, whatever you gain from having the lower risk free rate will be overwhelmed by the increase in the equity risk premium and the lower real growth. Thus, as I noted in an earlier post, a lower risk free rate does not always translate into higher equity values. The most charitable assessment I have of the market's optimistic reaction to the Fed’s action is that the market buys, at least for the moment, into the Fed’s juggling act: that they can keep interest rates low, without increasing macroeconomic risk, while spurring real growth in the economy. I think you could point to a more likely scenario where QE3 does not do much for real growth, while leading to more uncertainty about expected inflation (and higher equity risk premiums) and the net effect on stocks is negative.

Given high unemployment and an economy stuck in neutral, you may feel that the Fed had no choice. After all, doing something is better than doing nothing, right? That would be true, if QE3 were costless, but it does carry three costs:

1. The inflation factor: The biggest cost of an expansionary monetary policy is the potential for inflation that comes with it. I know that the low inflation over the last few years has led some analysts to conclude that the inflation dragon has been slain forever.  However, history tells us that inflation is like a deadly virus, harmless as long as we can keep it trapped, but hard to control, once it escapes. Put differently, if the Fed has miscalculated and high inflation does return, the cure will be both long drawn out and extremely painful.
2. Artificially "low" interest rates create winners and losers: If the Fed's bond buying is keeping interest rates at "artificially" low levels, not everyone wins. Among individuals, spenders are rewarded and savers are punished, a perverse consequence in a nation that already saves too little for the future. Among businesses, you reward those businesses that have to raise fresh capital, and especially those who are more dependent upon debt, and punish more mature and/or equity-focused businesses. Among sectors, you help out those that are more dependent upon debt-funded consumption (housing, durable goods) and do less for service businesses. Thus, keeping interest rates "abnormally" low may create bubbles in some sectors and encourage people to act in ways that are not good for the economy's long term health.
3. Credibility effect: The powers of a central bank stem less from its capacity to print money (any central bank can do that) and more from its perceived independence and credibility, and I think the Fed has hurt itself on both counts. While I am willing to believe that the Fed acted without political considerations, any major action two months ahead of a presidential election will viewed through political lens, and it is natural for people to be suspicious. In addition, each time the Fed takes a shot at the "real growth" pinata and nothing happens, it damages it's credibility. Much as the market (and some economists) may welcome and justify QE3, but the ultimate test is in whether it will give a boost to real economic growth and if that does not occur, what's next? 

I was a skeptic on the efficacy of QE2 and Operation Twist and I remain unpersuaded on QE3. If the definition of insanity is that you keep trying to do the same thing over and over, expecting a different outcome, then we seem to be fast approaching that point with the Fed.

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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).

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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.

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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. 

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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.

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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!

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