SHOW ME THE MONEY: JANUARY 2018 DATA UPDATE 7. Aswath Damodaran

Transcription

1 SHOW ME THE MONEY: JANUARY 2018 DATA UPDATE 7 Aswath Damodaran

2 The Set Up In the last few posts, I have tried to estimate what firms need to generate as returns on investments, culminating in the cost of capital estimates in the last post. The other and perhaps more consequential part of the equation is what companies generate as profits and returns. Big Question: We will look at the returns generated by firms and compare them to the returns that they should have earned, with theintent of answering thequestion: Does growth add or destroy value? 2

3 Measuring Profitability - Margins 3

4 The Best Margin? Claimholder and Measurement End Game What are you trying to value? If your focus is on just equity investors, your focus will be on profits to equity investors, i.e,, net margin. In a DCF valuation built around pre-debt cash flows (FCFF) or if you are working with enterprise value multiples EV/FCFF, EV/EBITDA or EV/Sales), your focus will shift to operating multiples. What are you trying to measure? If you are attempting to compare production efficiency across firms, the gross margin is your best measure. If you are attempting to compare operating efficiency, at the business level, the operating margin is a better device. The net margin is almost never a good measure of operating efficiency, simply because it is affected significantly by how you finance your business, with more debt leading to lower net profits and net margins. 4

5 The Best Margin? The Life Cycle 5

6 The Best Margin? Selling Imperatives Better sell: Since margins get higher as you move up the income statement, business promoters are more inclined to use gross and EBITDA margins to make their cases than after-tax operating or net margins. Desperation Time? While that is perfectly understandable, and even justifiable, for a young company that is scaling up (see life cycle bullet above), it is a sign of desperation when companies continue to point to gross margins as their measures of profitability as they age. 6

7 Margins: Cross Sectional Distribution 7 Aswath Damodaran 7

8 Margins, across sectors 8

9 Margins: Pluses and Minuses as measure of profitability Pluses Useful for comparison purposes and as the basis for forecasts for the future. It is also the metric that lends itself well to converting stories to numbers. Minuses If your focus is on answering the question of whether your company is a "good" or a "bad" company, looking at margins may not help very much. There are "low-margin" good companies, like Walmart, that make up for low margins with high sales turnover and "high-margin" bad companies, that invest a great deal and sell very little, with many high-end retailers and manufacturers falling into this grouping. 9

10 Accounting Return Unlike profit margins, where profits are scaled to revenues, accounting returns scale profits to invested capital. There are only two consistent measures. ROE: The first is to scale net income to the equity invested in a company, measured usually by book value of equity, to estimate return on equity. ROIC: The other is divide operating income, either pre-tax or post-tax, by the capital invested in a company, to estimate return on invested capital. 10

11 1. Claimholder Consistency 11

12 2. Accounting Measure 12

13 My Estimation Choices 13

14 Excess Returns: Cross Section 14

15 Normalized Excess Returns: Cross Section 15

16 Cross Sectional Differences: Geography Return on ROIC - Cost of % with +ve Sub Group Number of firms Capital Cost of Capital Capital Excess Returns Africa and Middle East 2, % 8.76% -2.88% 34.55% Australia & NZ 1, % 7.97% -3.26% 31.88% Canada 2, % 8.39% -2.70% 19.07% China 5, % 8.13% -3.02% 45.57% EU & Environs 5, % 7.74% -2.24% 43.80% Eastern Europe & Russia % 9.03% 0.60% 41.67% India 3, % 8.96% 1.38% 40.24% Japan 3, % 7.74% -2.11% 45.06% Latin America & Caribbean % 8.80% -2.12% 43.63% Small Asia (wo China, India & Japan) 8, % 9.33% -2.12% 32.60% UK 1, % 7.78% -2.24% 47.62% United States 7, % 7.50% -0.75% 36.41% 16

17 Cross Sectional Differences: Sectors Industry Name ROC Cost of Capital (ROC - WACC) Electronics (Consumer & Office) -5.54% 7.67% % Oil/Gas (Production and Exploration) 0.09% 7.76% -7.67% Oil/Gas (Integrated) 2.15% 8.45% -6.30% Green & Renewable Energy 1.94% 5.77% -3.83% Shipbuilding & Marine 4.88% 8.26% -3.38% Real Estate (Development) 2.27% 5.21% -2.93% Insurance (General) 2.82% 5.38% -2.55% R.E.I.T. 3.08% 4.43% -1.35% Real Estate (General/Diversified) 4.32% 5.58% -1.26% Auto & Truck 3.97% 5.06% -1.09% Oilfield Svcs/Equip. 6.42% 7.44% -1.02% Telecom (Wireless) 5.43% 5.72% -0.29% 17

18 Cross Sectional Differences: Size Market Cap Class Number of firms Return on Capital Cost of Capital ROIC - Cost of Capital % with +ve Excess Returns Smallest 4, % 8.38% % 9.97% 2nd decile 4, % 8.71% % 14.13% 3rd decile 4, % 8.53% % 20.58% 4th decile 4, % 8.38% -8.72% 27.66% 5th decile 4, % 8.32% -6.17% 32.86% 6th decile 4, % 8.27% -4.33% 39.65% 7th decile 4, % 8.07% -5.33% 44.30% 8th decile 4, % 8.05% -2.55% 48.22% 9th decile 4, % 7.90% -1.81% 54.12% Largest 4, % 7.48% -1.73% 62.24% 18

19 Cross Sectional Distribution: Growth Growth Class Number of firms Return on Capital Cost of Capital ROIC - Cost of Capital % with +ve Excess Returns Lowest Growth 2, % 8.65% -6.98% 10.04% 2nd decile 2, % 8.48% -2.46% 21.47% 3rd decile 2, % 8.07% -2.48% 30.79% 4th decile 2, % 7.88% -1.54% 36.72% 5th decile 2, % 7.94% -3.01% 44.19% 6th decile 2, % 7.97% -1.58% 49.17% 7th decile 2, % 8.06% -1.62% 52.35% 8th decile 2, % 8.09% -1.50% 53.27% 9th decile 2, % 8.22% -4.09% 53.76% Top decile 2, % 8.20% 1.33% 45.49% 19

20 Conclusion The excess returns across companies are a good window into so many of the phenomena that are convulsing companies, businesses & economies today. Not only do the numbers indicate that growth plans are often more likely to destroy value, than increase it, but they also let us see how disruption is changing businesses around the world. If there is a common theme, it is that change is now par for the course in almost every business and that inertia on the part of management can be devastating. 20