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samedi 26 mars 2011

Damodaran: like the good Wine gets better as the Time goes by...

Is Professor of Finance at the Stern School of Business at NYU, teaching classes in corporate finance and valuation, primarily to MBAs.

We had a sort of one way confrontation last year in May. 
He is a bright mind, likely the best in the world in Valuing business from a pure fundamental stand point (except few flaws in intangibles in specifics domains like Luxury) . 
Inloved with the science as I am , is an enormous pleasure to read him after 1 year less deterministic and .... 
A real, real pleasure grown with the joy of being buried in his intellectuals contributions extremely detailed and...perfect in their domain, let's say.



Catastrophe and consequences for value

The airwaves have been inundated with news about natural disasters in Japan and their aftermath. Without minimizing the human impact - the thousands who have lost their lives and belongings - and the dangers of a nuclear meltdown, I want to focus on the impact of catastrophes, natural or man-made, on markets and asset values. While each disaster is different, here are some common themes that emerge after the disaster:

a. Our definition of "long time periods" is woefully inadequate: After the quake, which measured 8.9 on the Richter scale and ranked as one of the five strongest in recorded history, it was noted that nothing of this magnitude had been seen in Japan over the last 300 years. Since much of the regulation (of construction and nuclear power plants) had been structured based upon past history, they proved inadequate for the quake. As I look at how much of what we do in corporate finance and valuation is based upon time periods of 80-100 years (if we are lucky) and 10-20 years (if we are not), I wonder how much we are missing as a consequence of our dependence on the past........

 b. Experts are always "surprised" and are exceptionally good at ex-post rationalization: I am not that knowledgeable about earthquakes, but as I watched earthquake experts on the news in the days following the quake, I was struck by how much they reminded me of financial experts after the banking crisis in 2008 in their messages. First, for the most part, they admitted to be surprised by both the magnitude and the location of the quake (just as banking experts were surprised by the magnitude of and players in the sub-prime crisis). Second, they waxed eloquent about how uncertain they were about  long term consequences.... which leaves me wondering why we call them experts in the first place.
c. The doomsayers will have their day in the sun:  In the aftermath of every crisis, there will be people who emerge from the woodwork to say "I told you so". They will be feted as celebrities and treated as oracles, at least for a while. My response is less positive. After all, I have walked by the crazy preacher in Times Square almost every weekday, for close to 25 years, and he has warned me every single time that I have passed him that the end of the world was coming... He did sound prescient on September 12, 2001, but he was bound to, sooner or later. That is the reaction I have to those who preach doom and gloom all the time. They will be right at times but I will not attribute that success to wisdom but to accident....
d. Managing catastrophic risk exposure is much more difficult than managing continuous risk exposure: As companies and investors with Japanese risk exposure struggled with the aftermath of the disaster, I was reminded again of how much more difficult it is to manage and deal with discontinuous risk than continuous risk, especially if that risk occurs infrequently and has large economic consequences. In fact, this is the reason that I argued that companies that think that operating in authoritarian, stable regimes is less risky than operating in democratic chaos are mistaken. It is also the reason why managing exchange rate risk in a floating rate currency is much easier than managing that risk in a fixed rate currency.

I am not a deep thinker and am more interested in the prosaic than in the profound,  but I would like to address two questions that I have been asked in the last two weeks:

i. Are the markets reacting appropriately to the news?
While my instincts, based upon everything I know about behavioral finance, would lead me to say that markets  overreact to crises, I am not convinced by the analysis that I have read that make this argument with the Japanese tsunami. While much of the commentary has noted that the market value lost (in the Nikkei) has been disproportionally large, relative to the cost of of the damage, the definition of cost (as damage to existing assets) seems crimped.

As I see it, there are three levels of cost from any catastrophe:
a. Damage to existing assets: This is measured, either in terms of book value (or what was originally spent to build or acquire these assets) or replacement cost (to replace the damaged assets).
b. Loss of earnings power: The true value lost in a catastrophe is not the original cost, replacement cost or book value of the assets destroyed but the present value of cash flows lost in future periods as a result of the loss. Thus, when a factory with a book value or replacement cost of $50 million collapses, the value lost is the present value of the expected cash flows that would have been generated by the factory. If the firm was generating returns that exceeded its cost of capital, the value from the foregone cash flows will exceed $ 50 million.
c. Psychic damage: Catastrophes create psychic damage by reminding investors not only of their own mortality but of the fragility of the assumptions that they make to justify value. After all, in discounted cash flow valuations, we assume that cash flows  continue in perpetuity for most companies and that big chunks of value (especially for growth companies) come from expectations of excess returns from investments that firms will make in the future. To the extent that catastrophes shake this faith that investors have in the future, they can create significant damage to the value of growth assets.

The change in market value after a catastrophe will reflect these costs to varying degrees.
  • For mature businesses that generate little in terms of excess returns, the loss in value will approximate just the damage to existing assets (since the present value of cash flows should be close or equal to the book value). 
  • For mature businesses that generate returns on their investments that exceed the cost of capital, the value loss will be higher than the replacement cost or book value of existing assets and be more reflective of the lost cash flows. 
  • For growth firms, the loss in value can be extensive (as expectations of future growth get downgraded) even though they may suffer the least losses to existing assets.
If you are a contrarian or value investor, who believes that the psychic damage is transitory, there is an investment strategy that emerges from the rubble. It is not to invest in the entire market (all Japanese stocks) or in companies that have dropped the most in price (because some  may be mature companies like Tokyo Electric Power that have suffered significant loss of earning power), but to pick those companies where the price drop is more the result of the psychic reaction than the economic costs. (Multinationals like Honda, Toyota and Fuji that are Japanese in origin but have both their revenues and operations spread over the world would be a good place to start looking.) The risk, of course, is that the psychic damage is long term and not easily reversed.

ii. How do you incorporate the risk that catastrophes can occur in the future into valuation models?
If we define catastrophes as low-probability, high-impact events that affect most companies in an economy, there are three ways in which we can incorporate those events into value:
a. Adjust cash flows for an expected insurance cost: The simplest mechanism for building in the potential for catastrophes is to estimate the cost of insuring against catastrophes and building that cost into the expected cash flows. This, in turn, will lower the cash flows and value of every asset. It may be difficult to do for two reasons. The first is that some catastrophes may be uninsurable and getting an estimate of the insurance cost is not easy. The second is that even if there are insurers willing to provide coverage, a large enough catastrophe may render them incapable of backing up their promises (by making them insolvent). Note also that insurance covers only the first of the three levels of costs - damage to existing assets - and provides little protection against the other two levels - loss of expected cash flows and loss in growth asset value.
b. Use a higher risk premium: When buying risky assets, investors attach a risk premium to their required returns- an equity risk premium in the equity market and default spreads in the bond market. Since catastrophes affect entire markets, one way in which investors can build their likelihood (and consequent damage) into value is by charging higher risk premiums. As a consequence, the potential for catastrophe will have a much larger effect on risky, high growth firms than on safer,  mature companies. (The higher risk premium will push up costs of capital for all firms, but growth firms will be more affected since they get more of their value from cash flows way into the future.) To me, this seems to be the most viable option, especially when faced with risks that occur rarely, have large effects and are difficult to quantify in cash flow terms. I had an extended post on this a few months ago.
c. Allow for a higher probability of truncation risk: As I noted earlier, we value companies assuming cash flows in perpetuity (or at least for very long time periods), and catastrophes can put firms at risk of default or distress. When valuing companies (especially those with significant debt or other obligations), we should not only be more cautious about long term assumptions but also explicitly build into value, the likelihood that the firm will not survive.


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