Every 5-10 years I like to re-read an updated version of my favorite book on valuation, Valuation: Measuring and Managing the Value of Companies by Tim Koller. I first read it in 1995, skimmed through it again around 2002, and have been reading the latest version. It always reminds of this important point:
"The guiding principle of value creation is that companies create value by investing capital they raise from investors to generate future cash flows at rates of return exceeding the cost of capital."
With this in mind, I have been considering the effect on business during a period of falling cost of capital. In 2009, Tim Koller estimated the cost
of equity capital for most large companies fell in the range of 8-10%
when the yield on the ten-year treasury was around 3% and they used a
risk premium of 5.4%. In the second edition of the book, published in
1994 using examples from the early 1990's when the 10-year treasury
yield was around 7%, the authors used a market risk premium of about
5-6%, which likely implied a cost of equity capital for most large
companies between 12-14%. From the debt perspective, the interest rate
for Triple-A corporate debt has declined from around 8% in the early 1990's to close to 3%.
If these findings are a fair indication of the fundamental trends in our economy, and not materially impacted by issues like survivor bias and other statistical problems, then it raises some significant questions. Among them:
(1) What impact has government policies had on ROIC versus fundamental economic trends?
Have patent laws enabled businesses to claim an unfair portion of the market? Are rounded corners on a cell phone and specific folding of cloth really "new" under law and deserving of patent protection. Has increased regulatory requirements in many industries simply raised the barriers to entry, thus enabling established businesses to charge higher prices? Was the Bush-era tax cuts the primary driver of higher ROIC, and what then do tax increases mean? Is corporate cronyism enabling certain businesses to capture excessive profit and diminishing competition?
On the other hand, did moving labor offshore provide a short-term (2-10 years) window of excess profit as costs declined while prices remained stable? Has social media improved business brand building and enabled established businesses to charge higher prices? Has technology advancements allowed a rapid decline in operating costs while allowing businesses to hold prices stable?
(2) Does ROIC return to a historically normal level, and how?
Do prices simply decline as competition intensives, suggesting deflation? Do businesses simply expand and then potentially falter as supply and demand shift to find a new equilibrium? Do government policies enable on-going elevated ROIC levels through regulation and patent law interpretation, or move to capture the excess profit through higher taxes?
(3) Was the period of 2004 to 2010 the best business environment ever?
If government policies and fundamental economic trends both favored business, and the cost of capital was historically low, could it have been any better for business? Did this excessive profit pump up the bubbles in the economy? Are these trends sustainable, or do they revert back to the historical norm? If they revert back, how long does it take and is it a headwind for the economy until equilibrium is again found?
(4) Switching to the cost of capital side, is monetary policy a coiled spring or a limp string?
Does the cost of capital suddenly spike upwards as the large build-up in excess reserves indicate inflation could rise rapidly, like a spring coiled tightly? Or, is the build-up an indication of the government "pushing on a string" to stimulate demand? Structural inefficiencies are allowing excess profit to be captured and maintained by certain businesses as competitive pressures have been weakened.
These issues are all debated in various forms, but unfortunately are usually boiled down to ridiculously simple arguments about "uncertainty."
My
point is that the cost of capital for a business has likely decreased
4-5% over the past twenty years, and likely continues to decline as the
Fed pushes long-term interest rates lower.
Basic economic theory argues that excess profit attracts competition until that profit goes away. This argument suggests that the rates of return on investment, or ROIC, have likely declined over the past 20-30 years as companies expanded and cut prices in an effort to capture the excess profit. However, I was surprised to see the statement in the book that,
Somewhat more confusing is the additional findings that,
Basic economic theory argues that excess profit attracts competition until that profit goes away. This argument suggests that the rates of return on investment, or ROIC, have likely declined over the past 20-30 years as companies expanded and cut prices in an effort to capture the excess profit. However, I was surprised to see the statement in the book that,
"The median ROIC, [excluding goodwill,] between 1963 and 2008 was around 10 percent and remained relatively constant throughout the period."
Somewhat more confusing is the additional findings that,
"However, there has been a recent shift toward more companies earning very high returns on capital, [excluding goodwill]. In the 1960s, only 1 percent of companies earned returns greater than 50 percent, whereas in the early 2000s, 14 percent of companies earned returns of that magnitude. In many cases, this improvement has occurred in industries with strong barriers to entry, such as patents or brands where gains that companies have made from decreased raw-materials prices and increased productivity have not been transferred to other stakeholders."
If these findings are a fair indication of the fundamental trends in our economy, and not materially impacted by issues like survivor bias and other statistical problems, then it raises some significant questions. Among them:
(1) What impact has government policies had on ROIC versus fundamental economic trends?
Have patent laws enabled businesses to claim an unfair portion of the market? Are rounded corners on a cell phone and specific folding of cloth really "new" under law and deserving of patent protection. Has increased regulatory requirements in many industries simply raised the barriers to entry, thus enabling established businesses to charge higher prices? Was the Bush-era tax cuts the primary driver of higher ROIC, and what then do tax increases mean? Is corporate cronyism enabling certain businesses to capture excessive profit and diminishing competition?
On the other hand, did moving labor offshore provide a short-term (2-10 years) window of excess profit as costs declined while prices remained stable? Has social media improved business brand building and enabled established businesses to charge higher prices? Has technology advancements allowed a rapid decline in operating costs while allowing businesses to hold prices stable?
(2) Does ROIC return to a historically normal level, and how?
Do prices simply decline as competition intensives, suggesting deflation? Do businesses simply expand and then potentially falter as supply and demand shift to find a new equilibrium? Do government policies enable on-going elevated ROIC levels through regulation and patent law interpretation, or move to capture the excess profit through higher taxes?
(3) Was the period of 2004 to 2010 the best business environment ever?
If government policies and fundamental economic trends both favored business, and the cost of capital was historically low, could it have been any better for business? Did this excessive profit pump up the bubbles in the economy? Are these trends sustainable, or do they revert back to the historical norm? If they revert back, how long does it take and is it a headwind for the economy until equilibrium is again found?
(4) Switching to the cost of capital side, is monetary policy a coiled spring or a limp string?
Does the cost of capital suddenly spike upwards as the large build-up in excess reserves indicate inflation could rise rapidly, like a spring coiled tightly? Or, is the build-up an indication of the government "pushing on a string" to stimulate demand? Structural inefficiencies are allowing excess profit to be captured and maintained by certain businesses as competitive pressures have been weakened.
These issues are all debated in various forms, but unfortunately are usually boiled down to ridiculously simple arguments about "uncertainty."
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