In response to the Great Recession, central banks continue to engage in massive monetary stimulus to artificially depress the costs of capital. Many commentators have expressed concerns (and I concur) about the inflationary forces they believe must naturally be building up because of this stimulus. Yet, very few commentators have discussed the consequential little worm that is destroying capitalism, and the mindset thus birthed.
Costs of Capital
Generations of business schools have taught — and business leaders have implemented — capital budgeting philosophies based on expected rates of returns and weighted average cost of capital (WACC). First, cash flows over a time horizon are estimated for a proposed project. On the positive cash-flow side, these may include additional revenues created or future expenses saved. Either way, there is some benefit to a business of the proposed project. Netted against these benefits are the negative cash flows — the expenses — that are expected to be incurred to implement the project. Next, the net flows over time are discounted by the WACC, and the assumed risks of successfully implementing the project are built into this discount rate. If the net present value (NPV) of this calculation is positive, then businesses are supposed to proceed with the project. Still, others prefer to compare their expectations for internal rate of return (IRR) to the WACC. Either way, the process is the same.
The Little Worm
But this entire framework has a problem — the little worm that is destroying capitalism, albeit slowly. Namely, in calculating cost of debt and cost of equity for businesses, market-based rates are used, and with the misnamed "risk-free rate" serving as the root of all other costs of capital. What happens though when central banks’ loose monetary policy creates too much capital and artificially holds down root costs of capital? Companies adjust their required rates of return down, too. In fact, one could argue that this is a principal reason for why central banks are holding root costs of capital so low: to spur business investment.
Yet when WACC is held artificially low, many projects are accepted that previously would never have been considered viable under normal circumstances. Put another way, the problem is using relative values — not absolute values — in calculating costs of capital. Examples of such projects providing marginal benefits are: improving financial reporting systems through better information technology, minor tweaks to supply chain logistics, cutting back on marketing or increasing low-cost advertising (like social media), “rationalization” of head count, holding average wages as low as possible, squeezing suppliers a little bit, not repatriating earnings to stave off taxation, refinancing rather than retiring debts, and the share buyback that is insensitive to a company’s current stock price. I could go on.
It is not that these marginal WACC projects are unworthy and shouldn't be done, it is that the lifeblood of capitalism is creative destruction. It is fiery and intense. Capitalism is supposed to be more like a volcano than a hot plate keeping the coffee warm!
Evidence that the worm is eating away at capitalism is that revenues continue to grow much more slowly than do earnings per share (EPS). Furthermore, revenues continue to miss consensus estimates even though EPS continue to beat estimates. Also, EPS continue to grow so quickly due mostly to a shrinking denominator (i.e., big share buybacks). Ask yourself: When was the last time you heard genuine risk-taking behavior on the part of your portfolio of businesses? I think you will agree that only a handful of companies are engaged in proper game-changing capitalistic risk taking.
Normalized Cost of Capital
In the developed nations, I estimate a normalized long-term project after-tax WACC of around 6.5%, versus an estimated late 2014 WACC of only 3.0%. Even if you disagree with my estimates, I believe if you calculate your own, you will find that current costs of capital are about less than half of a normalized figure. That means you should expect at least 100% more projects being approved than under normal cost of capital scenarios. Yet this high figure may actually understate the number of excess projects being funded. This is because as cost of capital asymptotically approaches zero (i.e., "to negative nominal yields and beyond!"), the actual number of projects thought of as viable may follow a power law distribution instead of behaving linearly. In other words, businesses are currently in the process of destroying what was, once upon a time, a precious resource to be conserved: capital.
A Remedy?
If you agree with me, I propose, as a simple remedy, that costs of capital for a business begin to be evaluated on an absolute, normalized basis, rather than on a relative basis. And, I would add, treating externalities as free/not considering economic, social, and governance (ESG) is not going to cut it either. As a shareholder — or prospective shareholder — you do not need to wait for a company to engage in this behavior. Instead, you can begin to use normalized costs of capital in your own estimates of fair value. This may shrink your universe of investible assets, so be wary of diversification being worse.
Fear the Worm
My big fear is that even once costs of capital begin to rise/normalize, a generation of gutless business leaders is being hatched in the current gutless business culture. In short, artificially low costs of capital are eroding the capitalist’s risk-taking, return-generating mindset. Yikes! In conclusion, which company would you rather invest in: the one using normalized costs of capital in capital budgeting, or the company just using traditional methods? Thought so!
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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29 Comments
Jason: it is a very engaging read. I read it twice and I am struggling to reconcile the final "gutless managers" point with the rest of the write-up. I am assuming you are (rightly) pointing out many "Type 1" errors in projects taken on today as a result of lower interest rates. I interpret this as capital managers growing more risk-tolerant, i.e. requiring lower absolute rates of return due to the relative rate framework. If anything, this should imply "too much gut" and too little selectivity of risk.
Yet, a quick "empirical" survey of corporate behaviors today suggests companies are still shy to fully invest their "pilling" cash, resulting in the mismatch between revenues and EPS trends you point out. This could be attributed to a continuing focus on controlling cost rather than growing, in my opinion, that stems from a Great Recession-relaated PTS syndrome, indeed fitting the "gutless" characterization.
I suppose what I am saying is, I miss the transition in the article or may need a couple of further reads.
Long time reader, first time commenter, and hopeful for some good level 3 results this August,
ilir
Hello Ilir,
Excellent news regarding you joining the comments stream - nice to know we have another learned, intelligent contributor out there.
I think you read my post correctly, but your interpretation and narrative of the facts differs from mine. My interpretation/narrative is that risks in the overall ecosystem have not actually lowered by much, but have been artificially kept low. In this environment, the prudent thing to do would be to continue to demand higher, absolute rates of return as compared with WACC. If firms still demanded 10-15% returns, but could fund at 3.5%, the spreads would be very high. Instead, firms have lowered their hurdle rates, since they are market based. Consequently, they are approving many dozens of projects and capital choices that would never normally pass muster. So I am saying that this is a risk to the system.
Also, I need to address my 'gutless' characterization because several comments have mentioned it. I did not say that corporate finance people were gutless, I said I fear that a generation of corporate managers is being hatched that will be gutless. I was trying to suggest that the future for corporate earnings looks bleak once costs of capital normalize because of the mentality I feel is developing. Right now what is missing is an appreciation for a once-in-a-lifetime opportunity to earn outsized returns on capital projects since funding costs are held artificially low. But instead, corporate finance pros are using relative spreads to evaluate projects. Ouch!
An analogy may help: The behaviors I witness are similar to the child that has been handed everything by a doting parent and had to work for nothing. When the subsidy of the child is rolled back the child does not know how to survive in the world because he doesn't know how to take risks, or to think very large about her life, or how to solve life's big problems.
I hope this helps to reveal my intent : )
Yours, in service,
Jason
Hi Jason,
It was a great article...the first of its kind that I have read actually.But I have one question, the trend till now always has been to tune investment rates as per market rates - relativity has always existed. If we wipe out relativity, how will the interest costs actually be calculated...
Thanks,
Priyamvada
Hello Priyavada,
Thank you for your compliment and for your question.
Let me try to clarify...I am not saying to scrap the intellectual framework for executing corporate finance. Instead, I am saying that capital decision makers need to recognize that costs of capital are artificially held low, and that very low return projects are consequently being approved that would never normally be approved in a regular costs of capital environment. This is creating a large risk for the future of capitalism to my mind.
My suggested framework is for firms to continue to fund themselves with the ridiculously low costs of capital available to them (around 3%) and likely using 100% debt, but to raise their required rates of return back to normalized levels (i.e. 10-12%). This should create an outsized spread and lead to the approval of fewer projects, but they are likely to be "game-changers." Instead, though, corporate finance pros are adjusting their mindsets to only see the world as containing low return, low risk, non-game changing projects.
Once interest rates normalize - i.e. central banks pull back on their massive stimulus activities - then firms can maintain their required rates of return, WACCs will increase, and a return to the normal "relative rates" based capital budgeting will return.
Does this make sense?
Yours, in service,
Jason
Hey!!
I can understand why you would suggest to use normalized WACC but then what about cash flows? Shouldn't they also be protected as if we are in a normalized word? I think Prof. Damodaran had raised this point in his blog and has suggested to use the actual WACC and then also project cash flows actually because the normalized world doesn't exist. Can you please throw some light on the same?
Hi Moksh,
Point 1, Normal Environments Do Exist: I think it is entirely fair to think of a "normalized world" existing in financial markets. Let me share with you an example. Take a look at www.cfapubs.org and look for a game-changing and amazing article written by the late, great Peter Bernstein and the still vibrant Rob Arnott (http://www.cfapubs.org/doi/pdf/10.2469/faj.v58.n2.2524). The paper was about long-run equity returns relative to debt returns - they went back over one hundred years. The conclusion was that the run up in equity prices from around 1980-2005 was unprecedented in human history and that they were not reflective of reality. Bernstein and Arnott's point was that prudent portfolio managers should use normalized return expectations when thinking about the future direction of equity markets. So, too, should pension funds think of normalized rates of return on various asset classes.
Point 2, Independent Estimates of Cost of Capital: Many people do not spend the time to consider the philosophy underlying rates of return and costs of capital. Why do they exist? They exist because there are distortions to equilibrium created by time, space, preferences, risks, and so forth between one person's surrender of capital to someone else. In other words, what leads to someone else forgoing use of capital right now to someone else? A cost of capital, or required rate of return, clearly. I would argue that there are permanent factors that can be baked into costs of capital, including information asymmetries, different funding time horizons, different perceptions of risk, and so on. The creation of the Internet has permanently lowered the cost of information discovery for everyone, so you would expect that costs of capital would be permanently lower because of the Internet's existence. That said, there are different interpretations of factual data, and different ways of discounting the future. So there are going to be differences of opinion in costs of capital between providers of capital and users of capital. Here, cost of capital can be negotiated between the two parties to adjust for differences of opinion.
You might also expect there to be adjustments for all other factors, too. My point is that you could build theoretical costs of capital without using markets, and this would be independent of current market activity. I think there is such a thing, costs of capital independent of market activity. We use market rates, not necessarily because they are correct, but because they are convenient when we build our models. In normal circumstances we can use market rates because they are likely to be relatively unbiased, and reflective of a number of market participants' beliefs about what capital ought to cost. However, what are prudent capital decision makers to do when there are large scale distortions in a system? Here, an estimate of cost of capital independent of distortions is called for.
To summarize this point, my belief is that markets are not always efficient and that it is possible for entire markets to be poor price estimators (i.e. bubbles do happen). When these environments exist - and I think that is exactly the environment we are in right now - then it makes sense to create a non-market based estimate of cost of capital.
Point 3, Don't Double Count Risk - Discounted cash flow analysis can handle estimates of risk and return in two places:in the estimated cash flows and in the require rate of return. It sounds as if Aswath counsels to handle this in the flow portion of the equation. I am arguing that in the current environment if you are to handle estimates of required rates of return that it is dangerous to use market-based rates. SUPER importantly, when building a discounted cash flow model (same as a capital budgeting model) then it is critical that you do not double count risk. In other words, if you handle the risk in the estimate of cash flows, then do not double count risk in the cost of capital. The reverse is also true. If Aswath counsels handling risk in flows, I am certain that he has good reasons for it. I am counseling that people are likely using the wrong estimate of risks in the required rate of return portion.
Point 4 - The beautiful thing about investing is that results are not subjectively measured, but objectively. Yet, analysis is subjectively executed, not objectively. Meaning that, we all have our opinions : ) and I am certain that your perspective is also a valuable one.
Thank you, thank you for your interest in The Enterprising Investor!
Jason
Hello Jason,
Another thoughtful piece.
I know this is a US centric issue (low risk free rate) yet important to the rest of the world. In my part of the world (India) corporate managers largely use qualitative factors over quantitative factors while evaluating decisions.
So that is a right brain approach, right :)
For example, managers ask - how we do capture markets 5 years hence if we invest now. Should we invest in project A so that smaller projects B,C,D can be easily won easily, if we win A. Should we partner with company X for bidding for certain project A even though our share in the profits may be lower. Should we lever up 3x for a business that breaks even in 10 years. Should I invest in project A that gives me good advertising and visibility to the world while my rest of the business thrives.
One issue is I have never comprehended whether capital budgeting framework traditionally considers these aspects or not. The knock-on effects, the competitive threat factor, the rent-seeking that companies, rightly or wrongly, aspire to gain.
I am hazarding a guess that similar issues and manager traits might be present in the US as well.
I am also deeply influenced by Buffet's statement that cost of capital is not a precise number for all, but the opportunity cost of the next best thing to each one. Many companies in India imbibe that thought quite naturally.
Thank you again for an interesting piece.
Regards
Ashok
Hello Ashok!
Thank you for sharing the Indian story with the audience. Super interesting information that you have shared.
Yours, in service,
Jason
Thanks for the article Jason, it's brilliant. It reminds me to the ideas brought by austrian economists (Menger, Böhm-Bawerk, Mises, Hayek, etc). My question is: these economists state that we suffer business cycles due to the manipulation of interest rates by Central Banks, not allowing economic agents to make proper capital budgeting decisions by receiving the wrong signal (level of interest rates not backed by savings). But at the end, Central Banks manipulate short term "risk-free" rate, what you call the root. Above that root there are several spreads (maturity, creit risk, expected inflation, etc.) which are set by markets. Wouldn't be the final result of adding the base or root with all spreads the same as in a pure free market where interest rates would be set freely? Maybe in a pure free market we would start from a higher root but then we would add lower spreads. Thank you in advance!
Hello Alberto,
First, thank you for the high praise for the piece. I felt compelled to write this piece because I think the life blood of capitalism is innovation, and since 2009 most of the innovation being expressed at companies is in the form of financial engineering (debt refi, stock buybacks), and not of the 'how do we grow our top-line' kind,
Second, I am sympathetic to the Austrians' fascination with free-markets. But, in practice and in my opinion, it is a Utopian ideal (and the polar opposite of the Utopian-ideal of pure socialism) that will never be achieved. This is a much broader conversation than I am prepared to fully express in the comments section, too. But I will say that my initial assumption about markets is that they are not truly free, not truly a perfect pricing mechanism, and they are frequently manipulated by various authorities. Some of the authorities are central banks and bureaucratic entities, but still others are market enthusiasts themselves (see: LIBOR, for example). Given this assumption, my goal as a financial professional is to recognize when markets are far from a normal range of typical distortions, and to then use adjustments. I think this is an elegant solution to an imperfect world.
Again, thanks for making me smile today!
Jason