Session 26: The End Game

Key Concepts

Live Cases: Real-world business situations that are ongoing and unpredictable, making them challenging for analysis.
Estimates vs. Facts: The prevalence of estimations over concrete facts in financial analysis, requiring judgment and best guesses.
Dynamic Business Environment: The constant change in business models, market conditions, and political influences.
Stakeholders: Shareholders, lenders, financial markets, and society, each with distinct interests in a company.
Shareholder Power: The varying degree of influence shareholders have over management decisions.
Marginal Investor: The investor whose decisions drive market prices, typically institutional investors in diversified portfolios.
Cost of Equity: The return required by equity investors, calculated using the risk-free rate, beta, and equity risk premium.
Risk-Free Rate: The theoretical rate of return on an investment with zero risk, often approximated by government bond yields.
Beta: A measure of a stock's volatility in relation to the overall market, representing undiversifiable risk.
Equity Risk Premium (ERP): The excess return that investors expect to receive for investing in the stock market over a risk-free rate.
Bottom-Up Beta: A beta calculated by analyzing the betas of comparable companies in the same business lines.
Regression Beta: A beta calculated by regressing a stock's historical returns against market returns.
Cost of Capital: The blended cost of debt and equity financing for a company, used as a hurdle rate for investments.
Cost of Debt: The interest rate a company pays on its borrowings, adjusted for tax benefits.
Debt-to-Capital Ratio: The proportion of a company's financing that comes from debt.
Return on Equity (ROE): Net income divided by book value of equity, measuring profitability relative to shareholder equity.
Return on Capital (ROC): Operating income after tax divided by invested capital, measuring profitability relative to all capital invested.
Jensen's Alpha: A measure of a stock's performance relative to its expected return based on its beta.
Excess Return: The difference between a company's return on capital and its cost of capital.
Optimal Debt Ratio: The debt-to-capital ratio that minimizes a company's cost of capital.
Free Cash Flow to Equity (FCFE): Cash available to equity holders after all expenses, debt payments, and reinvestments.
Dividends and Buybacks: Methods of returning cash to shareholders.
Valuation: The process of determining the current worth of an asset or company, often using discounted cash flow (DCF) models.
Investment Principle: Taking investments that earn a return greater than the hurdle rate.
Financing Principle: Minimizing the hurdle rate by finding the optimal mix of debt and equity.
Dividend Principle: Returning cash to shareholders if profitable investments cannot be found.

Review of the Class and Project Analysis

The instructor begins by acknowledging the submission of project numbers and framing the review as a look back at the entire class, using the projects as a unifying element. The core challenge highlighted is the nature of "live cases" – real-world business situations that are dynamic and unpredictable, making definitive conclusions difficult.

Key Challenges in Real-World Analysis

Scarcity of Facts, Abundance of Estimates: The instructor emphasizes that financial data often consists of estimates, not hard facts. Even seemingly straightforward figures like cash and marketable securities can vary across different sources, necessitating the use of best judgments.
Messy and Changing Real World: Business models can falter unexpectedly, as illustrated by the hypothetical 100% tariff on foreign-made movies impacting Netflix. Companies that were initially money-making can become money-losing during the analysis period, presenting unexpected challenges.
External Factors: Market volatility (e.g., April's eventful yet uneventful performance) and political influences are now significant considerations, even for developed markets.
Model Limitations: Spreadsheet models and tools are not infallible. Errors in input numbers or model design can lead to strange outputs, and the responsibility ultimately lies with the user, not the tool. This principle extends to the age of AI.

Company Analysis Trends

The instructor notes common company choices for analysis, with Palantir being the most frequently analyzed, followed by Netflix, Chipotle, Pepsi, and Starbucks. Several other companies like EA, Shake Shack, General Mills, Lululemon, and Marriott were also analyzed by multiple groups.

The instructor uses Pepsi as an example to illustrate the variability in analysis even when multiple groups analyze the same company. Despite general agreement on institutional ownership and low betas, there were discrepancies in Jensen's alpha and R-squared values, likely due to different time periods used for regression analysis. This highlights that even with the same company, different perspectives and data slices can lead to dramatically different conclusions.

Stakeholders and Conflicts of Interest

The class began by examining the different stakeholders in a company and their inherent conflicts:

Shareholders: Own the company but often have limited power over management. They seek residual claims and upside potential.
Lenders: Have a contractual claim and prioritize the firm's ability to repay debt, leading to different risk appetites than shareholders.
Financial Markets: Engage in a tenuous relationship with firms, relying on information that may be selectively or inaccurately disclosed.
Firms and Society: The impact of ESG and sustainability is difficult to quantify and often requires regulatory intervention rather than voluntary corporate choices.

Conflicts of Interest:

Shareholders vs. Managers: Managers may prioritize their interests over shareholder interests due to limited shareholder power.
Lenders vs. Borrowers: Lenders must protect themselves to avoid being "ripped off."
Managers vs. Markets: Managers may delay or misrepresent information.
Markets vs. Rationality: Market prices don't always reflect rational behavior.
Companies vs. Society: Companies create social costs and benefits that are not always captured in financial statements.

Shareholder Power Analysis

Based on student input, approximately 10% of companies had shareholders with no power, often family-controlled or with dual-class shares. 36% had some, but not much, power, while 32% had more power, and 19% were perceived as being run by shareholders. This indicates that in most companies, shareholders do not wield as much power as traditionally assumed.

The Marginal Investor and Risk

The discussion shifts to the marginal investor, who is typically institutional. This is crucial because institutional investors are diversified. This diversification is the foundation of modern finance, as it changes how risk is perceived. For undiversified investors, company-specific risk is significant; for diversified investors, only systematic (undiversifiable) risk matters.

Implication for Cost of Equity: If the marginal investor is diversified, the focus shifts to betas (measuring systematic risk) rather than total risk. This explains why the instructor emphasized bottom-up betas over regression betas.
Risk-Free Rate: The US Treasury bond rate is commonly used as the risk-free rate, assuming no default risk. However, recent trends in US sovereign CDS spreads suggest a creeping fear of US default risk, potentially complicating the determination of a truly risk-free rate in the future.
Beta: Measures undiversifiable risk. Regression betas are criticized for being backward-looking, noisy (high standard error), and potentially useless if a company's business mix or leverage changes.
Bottom-Up Beta: This methodology builds a beta by identifying a company's business lines, finding comparable "pure play" companies, unlevering their betas, and taking a weighted average. This approach is considered more precise, less noisy, and more forward-looking as it's based on the expected business operations.

Beta Distribution in Student Projects

Median Beta: 1.14, indicating that the typical company analyzed was riskier than the average company (which should have a beta of 1).
Median Jensen's Alpha: 0.24%, with 52% of companies earning positive Jensen's alphas, suggesting better-than-expected performance after adjusting for risk.
Median R-squared: 11%, meaning that, on average, 89% of the risk was company-specific and ignored due to the assumption of investor diversification.

The instructor acknowledges that the requirement to pick "money-making" companies and avoid financial services likely skewed the sample towards higher-risk, positive-alpha companies.

Cost of Capital and Investment Quality

Cost of Debt

The cost of debt is calculated as the risk-free rate plus the company's default spread, adjusted for the tax deductibility of interest. The instructor notes that for most companies with low debt ratios (10-20%), the cost of debt has a minor impact on the overall cost of capital. However, for highly leveraged companies like MGM (74% debt ratio), it's a significant factor. The tax shield is only applicable if the company is profitable.

Debt Ratios and Optimal Debt

Actual Debt Ratios: The median debt ratio for analyzed companies was 15%, with the third quartile at 27%. This indicates that most companies were lightly levered.
Casino Companies: Companies like MGM, Wind Resorts, and Las Vegas Sands tend to have high debt ratios due to expensive investments and a desire by management (often described as "megalomaniacs") to retain control rather than issue equity.
Optimal Debt Ratio: The median optimal debt ratio was around 30%, with 50% of companies falling between 10% and 40%.
Drivers of Optimal Debt: Key drivers include tax rates, bankruptcy costs, and, crucially, the ratio of cash flows to market value. Companies with high market valuations (like Palantir or Nvidia) tend to have lower optimal debt ratios because even a small percentage of their value represents a large amount of debt, making interest payments difficult to cover. Conversely, companies with volatile earnings or a broken business model might have higher optimal debt ratios.
Underleveraged vs. Overleveraged: The median company was found to be underleveraged (actual debt ratio lower than optimal). This is generally preferred to being overlevered, as seen in historical examples like Korea in the 1990s, where overleveraging led to a financial crisis.

Quality of Existing Investments

Return on Equity (ROE) and Return on Capital (ROC): These accounting-based metrics are used to assess investment quality. However, they are flawed and can be manipulated.
Negative Book Equity: At least 25 companies had negative book equity, often due to sustained losses or significant share buybacks.
Median Company Performance: The median company in the class earned a ROC 5.56% higher than its cost of capital, indicating it was in the top 30% globally in terms of earning its cost of capital. This suggests the analyzed companies were already exceptional.
Jensen's Alpha vs. Excess Return:
- Jensen's Alpha: Measures stock performance relative to expectations.
- Excess Return: Measures project profitability relative to the cost of capital.
- These can diverge. A company can have positive Jensen's alpha (market likes it) but negative excess return (projects are not earning their cost of capital), or vice versa. This divergence is explained by expectations. A company consistently exceeding expectations will be punished if it merely meets them, while a consistently poor performer might be rewarded for simply meeting expectations.

Valuation and Company Value

Optimal Debt Ratio Calculation

The instructor provided a tool to calculate the optimal debt ratio. The median optimal debt ratio across student companies was approximately 30%.

Under/Overleveraging

The median company was found to be underleveraged, meaning its actual debt ratio was lower than its optimal debt ratio. This is a positive sign, as being underleveraged is generally less risky than being overlevered.

Financing Choices

The instructor advised matching debt maturity to asset life and currency mix to business operations. Companies with pricing power might favor floating-rate debt.

Dividends and Buybacks

Cash Flow to Equity: Calculated by starting with net income, adding back non-cash charges, subtracting changes in working capital, capital expenditures, and acquisitions.
Free Cash Flow to Equity (FCFE): Cash left after all needs are met, representing what a company can afford to pay out.
Cash Return: The median company returned about 73% of its FCFE, with buybacks accounting for approximately 60% of the total cash returned. This trend of buybacks dominating dividends is increasing over time.
Building Cash: If a company doesn't return all its FCFE, the cash builds up. This is acceptable if management is trusted (e.g., Apple), but concerning if management is overconfident or impulsive.

Valuation Frameworks

Two primary valuation frameworks were discussed:

Equity Valuation: Discounting cash flows to equity (FCFE or dividends) at the cost of equity.
Firm Valuation: Discounting free cash flow to the firm (FCFF) at the cost of capital. This yields the value of the entire business, to which cash is added and debt is subtracted to get equity value.

Valuation Results

Median Company Valuation: The median company was found to be overvalued by approximately 20% (price divided by DCF value was 120.33%). 155 companies were overvalued, and 70 were undervalued.
Historical Trend: Over the past 25 years, the trend has been towards more overvalued companies.

Changing Company Value and Parting Thoughts

The instructor posed the question of whether company value can be changed, highlighting that the levers are within the framework:

Investment Decisions: Taking better projects in good businesses, fewer in bad ones.
Financing Decisions: Optimizing the debt/equity mix to lower the cost of capital and matching debt to assets.
Competitive Advantages: Building them to extend growth horizons.

The instructor stressed that any proposed change must demonstrably impact the financial inputs (cash flows, cost of capital, growth rates). Sustainability, for example, needs a clear pathway to showing up in cash flows, even if in the long term.

The "Trifecta" of a Great Investment Opportunity

The instructor identified a rare "trifecta" of characteristics for a potentially great investment:

Return on Capital > Cost of Capital: The company is taking good projects.
Underleveraged: The company has too little debt relative to its optimal level.
Paying out too little cash: The company is holding back cash despite having good projects and being underleveraged.
Undervalued: The market price is below the intrinsic value.

CrowdStrike was presented as an example that met some of these criteria, though with caveats regarding governance and the accuracy of invested capital figures.

Core Principles of Corporate Finance

The class concluded by reiterating the fundamental principles:

Investment Principle: Pursue investments earning returns greater than the hurdle rate, based on cash flows and risk.
Financing Principle: Minimize the hurdle rate through an optimal debt/equity mix and matching debt to assets.
Dividend Principle: Return cash to shareholders if profitable investments cannot be found.

Final Advice

Big Picture Thinking: When stuck, elevate to the big picture to understand where a problem fits.
Pragmatism over Purity: Be willing to bend rules or models to apply concepts in the real world.
Overcoming Being Stuck: Develop the ability to move past challenges, as being stuck prevents progress.
Finding "Aha!" Moments: Look for connections between phenomena and existing questions to foster insight.
Course Evaluations: A reminder to complete the course evaluations, as they are necessary for grade release and can save the instructor from numerous emails.

The instructor also announced a sabbatical and will not be teaching valuation in the upcoming year, but plans to return in Spring 2027.