What to Use as the Equity Risk Premium?

I'm teaching Corporate Finance again this semester. In the class, we spend a fair bit of time on the CAPM (yes, I know - it's not perfect. But it is a still pretty good). One of the big issues is what to use as the Market Risk Premium (or, as it's sometimes called, the "Equity Risk Premium). Looks like I'll be using this piece as background: The Equity Risk Premium in 100 Textbooks by Pablo Fernandez of the University of Navarra. Here's the abstract:

I review 100 finance and valuation textbooks published between 1979 and 2008 (Brealey, Myers, Copeland, Damodaran, Merton, Ross, Bruner, Bodie, Penman, Weston, Arzac...) and find that their recommendations regarding the equity premium range from 3% to 10%, and that several books use different equity premia in different pages.

Some confusion arises from not distinguishing among the four concepts that the word equity premium designates: Historical equity premium, Expected equity premium, Required equity premium and Implied equity premium.

Finance professors should clarify the different concepts of equity premium and convey a clearer message about their sensible magnitudes.

It's worthwhile reading - you can download the full version on SSRN here.

HT: Jim Mahar at FinanceProfessor.com

Capital Structure, Buybacks, and Free Cash Flow

I'm in the process of putting together material for my Advanced Corporate Finance class. Of course, it has a module on capital structure and payout policy. One of concepts we'll get across is that holding extra cash often gives managers incentives to invest in negative NPV projects (the old "free cash flow" problem). So, according to agency theory, managers should lever up and pay out the excess cash to shareholders in the form of buybacks and/or dividends. Unfortunately, higher leverage and lower cash holdings exposes the firm to increased risk of financial distress.

Along those lines, I was going through my "clippings file" and came across this piece in the Economist. It discusses some of the costs of excess debt during recessions. Of course, it's always easy to look back after the fact and say that firms shouldn't have levered up so much, since it means they'll face distress costs during a recession (hindsight's always 20/20, after all).

In a related piece David Merkel id a piece a while back on financial slack and how he uses it in evaluating cyclical companies in Real Money. He illustrates his approach using the steel industry. When identifying good companies in the steel industries he looks for several things:

...With a cyclical company, watching the pricing trends of the commodity produced is the most critical factor in short-run stock performance. Longer term, it comes down to finding companies that have these four characteristics:

1. They're industry leaders with impeccable balance sheets.

2. They have reasonable operating leverage; they should be profitable at the cycle trough.

3. Their industry is hated, so their stocks can be bought at a cheap price.

4. They use free cash flow at a cycle peak in a way that prepares for the trough.

...Points 2 and 4 suggest a corporate humility that arises from restraining the increase of productive capacity when times are good, and a willingness to invest when times are bad.

Point 4 is the most relevant to the whole leverage/payout discussion: what's the best use of free cash flow? Should it be invested, used to pay down debt, or be distributed to shareholders? If good time are expected to continue, the company is best off investing the excess in positive NPV projects and then paying out excess free cash in the form of dividends and buybacks (and buybacks result in increased leverage). However, if troble is expected ahead, they're better off paying down debt or holding more cash in reserve.

I think it'll make for a good discussion in class.

Cost of Corporate Borrowing is Up

Because corporate borrowing costs were low in recent years, many companies loaded up on debt. Now, much of that debt is coming due at a time when companies have experienced slowdowns. Here's a recent article from the NYTimes Online, titled "Cost of Borrowing Zooms up For Corporations":

Like consumers and homeowners, America’s corporations binged on easy credit when times were flush, racking up huge debts. Now the bills are due, and paying them back will not be easy, or cheap.

This year alone, more than $700 billion in corporate loans will come due, according to Standard & Poor’s. That is the size of the federal bailout of the financial sector. Many companies were counting on being able to borrow more money to meet those obligations and kick their debt farther down the road.

But with the credit markets still tight, corporations are being forced to pay much higher interest rates than they did a few years ago, putting more strain on balance sheets already hammered by falling profits and a grinding recession.

Read the whole thing here

Buffett Buys A Piece of Goldman

It's a good time to be teaching Corporate Finance. Buffett's latest move (making a substantial investment in Goldman Sachs) is bound to make it into a lot of class discussions. The Wall Street Journal's take (at least, as expressed by Georgetown finance professor James Angel) is

Berkshire's plan "is a sign of confidence from one of the nation's most respected investors," said James Angel, a finance professor at Georgetown University, who added that "sharp investors" now are "sniffing around the wreckage of the credit crunch to pick up good assets on the cheap."

I think the second part of the statement is closer to the truth than the first. Here's what the Sage of Omaha gets for his money

The deal is structured in two parts, giving Berkshire a stream of cash and potential ownership of roughly 10% of Goldman. Berkshire will spend $5 billion on "perpetual" preferred shares of Goldman. These are not convertible into equity but pay a fat 10% dividend.

Berkshire also will get warrants granting it the right to buy $5 billion of Goldman common stock at $115 a share, which is 8% below the 4 p.m. closing share price Tuesday of $125.05. At Goldman's roughly $50 billion market value, based on that closing price, exercising those warrants would give Berkshire about a 10% stake in Goldman.

So, while the preferred isn't convertible, he gets what is essentially "synthetic convertible preferred". In essence, he gets his preferred payouts if the stock price doesn't rise, and the option to buy stock at a discount if the price is above $115. So, in effect he has a combination of preferred stock and an in-the-money call option. Barry Ritholtz prices the warrants at approximately $1.5 Billion, giving Buffett an effective yield of 14%, and cites another source who estimates their worth at $3.5B, and a yield of 17%.

Once again, Buffett has been able to make an investment at a very attractive price. In times where there's a lot of turmoil, having cash on hand makes it easy to buy companies (or parts of them) at a bargain, and according to Berkshire's first quarter, they had $31 Billion on hand. So, Buffett had cash at a time when Goldman desperately needed it. As a result, he got a great deal.

Just Damn. That guy is smart.

Larry The Liquidator

I've started putting together my syllabus for the spring semester. I'll be teaching the advanced corporate finance class. I haven't taught this particular class for a couple of years, so I thought I'd change things around a bit this time. It's about 50/50 between lectures and cases, and this time around I think I'll play this clip from Other People's Money. It's the speech by Larry The Liquidator at the shareholders' meeting, and it's a pretty good representation of the PE/buyout/corporate selloff world's approach to things. It's also one of the best finance clips you'll find in any movie anywhere. .

Enjoy.

How Much Should CEOs Be Paid?

There's a great editorial in today's WSJ by Robert Reich, titled "CEOs Deserve Their Pay (note: online subscription may be required). He starts out with the usual facts that get compensation activists so lathered up: the average CEO compensation for a Fortune 500 firm made almost $11 million last year (about 364 times the average employee's salary), and the 20 highest-paid execs earned an average of 436 million.

Reich then goes on to explain the increase in CEO pay over time as a rational consequence of increasing competition. In other words, 50 years ago, most large firms were in oligopolistic industries, with stable unions and predictable revenue streams. So, CEOs were almost like quasi-bureaucrats.

In contrast, now the level of competition is so fierce (and entry barriers so low) that even small differences in managerial quality can result in huge changes in profitability and market value. So, having a slightly better CEO can result in big gains to shareholder wealth. Not surprisingly, shareholders (or actually, boards of directors acting on the behalf of shareholders) realize this, and end up bidding up the price of good CEOs:

So how does the modern corporation attract and keep consumers and investors (who also have better and better comparative information)? How does it distinguish itself? More and more, that depends on its CEO -- who has to be sufficiently clever, ruthless and driven to find and pull the levers that will deliver competitive advantage.

There are no standard textbook moves, no well-established strategies to draw upon. If there were, rivals would already be using them. The pool of proven talent is small because so few executives have been tested and succeeded. And the boards of major companies do not want to risk error. The cost of recruiting the wrong person can be very large -- and readily apparent in the deteriorating value of a company's shares. Boards are willing to pay more and more for CEOs and other top executives because their rivals are paying more and more for them. Former Home Depot CEO Robert Nardelli to the contrary notwithstanding, the pay is usually worth it to investors.

RTWT here

All in all, it's a great piece. But alas, after such great writing, Reich can't help himself, and finally reverts to type:

This economic explanation for sky-high CEO pay does not justify it socially or morally. It only means that investors think CEOs are worth it. As citizens, though, most of us disapprove. About 80% of Americans polled by the Los Angeles Times and Bloomberg in early 2006 said CEOs are overpaid. The reaction was roughly the same regardless of the respondent's income or political affiliation. But if America wants to rein in executive pay, the answer isn't more shareholder rights. Just as with the compensation of Hollywood celebrities or private-equity and hedge fund managers, the answer -- for anyone truly concerned -- is a higher marginal tax rate on the super pay of those in super demand. (emphasis mine)

Ah well. Other than that line, it's still a great piece, and well worth reading.

Baby Got WACC

For those of you who aren't business school geeks, WACC stands for Weighted Average Cost of Capital. It's the rate of return investor would require to invest in a project that represents the average risk of a company's assets. It's a major topic in corporate finance, and also one of the drier and more technical ones.

Not any more. Every year, the Columbia Business School MBA students poduce the Business Schol Follies. This year, Sir Banks-A-Lot brings a hilarious spoof of the rap song Baby Got Back in Baby Got WACC.

HT: Dealbook