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Growth Options

Explaining Stock Market Moves After the Fact

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Whenever the market moves sharply, the media feel compelled to offer an explanation.  Sometimes this is reasonable.  For instance, a sudden increase in reported inflation is likely to be bad news for the market.  But much of the time, there is no logical explanation for why prices have moved.  Steve Ross, the seminal financial theorist, said it best before his untimely death in 2017.  Professor Ross put it this way,

It is one thing not to be able to predict what asset returns will be since they will depend on news, and news, by definition, is information that has yet to be revealed.  It is another, though, to observe the movement of prices and not know why they moved after the fact.  I am particularly troubled that contemporaneous news seems to explain so little of the contemporaneous prices.

By contemporaneous news, Professor Ross had in mind the revelation of actual value relevant information such as announcement of last month’s inflation rate, not ex-post speculation or what biologist Stephen Jay Gould called “just so stories.”  Examples of such just so stories include things like rising fear of inflation and panic selling.

When most of a company’s value is attributable to growth options the problem is compounded.  Market values rest not on what a company is doing today, but what it could do in the future.  As we have noted repeatedly in this blog, dreams of the future can evaporate for no apparent reason.  The last six weeks have been a good reminder of that.  Why they evaporated at this particular juncture is anybody’s guess.

ROKU : Growth Options and Bubble Stocks

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ROKU, a member or our “Top Ten Bubble Stocks (that could drop 50% or more)” list that we published in early October, reported earnings yesterday. Despite beating both top and bottom line earnings estimates, the stock was down a staggering 22% today.

We have talked extensively about “growth options” on this blog.  (High Expectations Can Bring Big Risks).  Recall that a firm’s equity value can be thought as being comprised of two components: 1) The value of current operations (which includes 5 years of future expected growth) and 2) everything else which is the “growth options”.  For tech companies like Roku, the growth options often include distant future opportunities that investors envision.

ROKU’s value is largely based on the 2nd components – the growth options. Companies whose value depends primarily on growth options can be highly sensitive to even a whiff of slowing growth.  That was the case with ROKU.  Despite the good top and bottom line performance, the earning release foreshadowed slowing user growth.  The related decline in the value of the growth options swamped any good news about current operations, sending the stock down 22%.  This underscores the need for caution among those considering investment in companies whose value is largely dependent on growth options.

Intangible Capital and Growth Options: The New Source of Value

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            When analyzing a company’s financial performance there are three things that need to be disentangled: (1) the difference between book and market values, (2) the difference between tangible capital that appears on the balance sheet and internally generated intangibles that do not, and (3) the difference between assets in place and growth options.  This note addresses these issues using data for Alphabet, a company that is a poster child for growth options and investment in intangibles.
            The data for Alphabet are presented in Exhibit 1.  The data are not meant to be precise.  The goal here is to explore conceptual issues related to growth options and intangible capital.  As described by Koller, Goedhart, and Wessels (2016) calculating quantities such as net operating profit after adjusted taxes (NOPLAT) and operating invested capital involves careful attention to a host of small details.  Most of those details are not incorporated here so the numbers can be thought of as a first order approximation.  For illustrative purposes, it is assumed that aggregate investment spending on all types of intangible assets is equal to twice the spending on R&D.  This is meant to be on the high side so as to be sure to incorporate the wide variety of intangible assets that Alphabet has generated internally.  The intangible assets are assumed to have a ten-year life and are amortized straight line.
            The weighted average cost of capital (WACC) can used as benchmark for assessing the numbers in Exhibit 1.  Although estimates of the WACC depends on the assumptions made and the model employed, most estimates are in a range around 10.0%, so I will use that number.
            The are a number of features to note in Exhibit 1.  First, the combination of NOPLAT of $21.7 billion and book operating capital of only $79.0 billion results in a return on invested capital (ROIC) of 27.4%, well in excess of the WACC.[1]  Second, when investments in intangibles are capitalized the current intangible capital comes to $115.2 billion, bringing total invested operating capital to $194.2 billion.  That number is still far short of the market value of operating capital of $717 billion.  Third, when both NOPLAT and invested capital are adjusted to take account of intangibles, ROIC(adj) drops to 21.4%.  The adjustment for NOPLAT consists of adding back expenditures on intangibles and deducting amortization of intangibles.  For Alphabet, the impact of adding investment in intangible assets to the denominator outweighs the impact of adding back net investment spending to the numerator.
There are two explanations for the immense difference between the book value of invested capital, including intangibles, and the market value.  The first is that Alphabet’s investments in both tangible and intangible assets are positive net present value (NPV) projects at the start.  If an investment is positive NPV, as soon as the asset is put in place its market value exceeds the invested capital.  This begs the question of where the positive NPV projects come from.  In a competitive market, they would not exist.  The answer must be that they are attributable primarily to the pre-existing intangible capital – something that competing companies cannot replicate.  It is by combining the new investments with the pre-existing intangibles that positive NPV projects are created.  Some may say: what if the company simply scours the markets more carefully and, thereby, finds positive NPV projects?  But the ability to do such scouring is a form of intangible capital.  So once again existing intangibles are the source of the value creation.  Second, over time the market is continually reassessing the value of operating capital assets, including intangibles, based on the cash flows they are expected to produce.  Such reassessments can widen the gap between the amount invested in intangibles and their market values.
Turning to growth options, as defined originally by Myers (1977) growth opportunities, or growth options, are “best regarded as the present value of the firm’s options to make future investments.  The distinction being drawn here is between assets whose ultimate value depends on further, discretionary investment by the firm, and assets whose ultimate value does not depend on such investment.”   Myers then divides the total value of the firm into two parts: the value of the assets in place and the value of the growth options.  He does not attempt to describe how either is to be calculated for an actual company like Alphabet.
Before addressing the valuation of growth options, there is a preliminary question regarding the relation of intangible assets to growth options.  Consider two firms, one of which has valuable growth options and the other of which does not, they must currently differ in some way that accounts for the existence of the growth options.  That difference presumably is some type of intangible capital.  Admittedly it may be difficult to identify exactly which intangible assets produce the growth options for one company and not the other.  For instance, the growth options might be related to more nebulous intangibles such as the organizational structure of the company or the skills of the employees, but whatever the precise source, the growth options must be related to some intangible assets that one firm possesses but the other does not.  This implies that if intangible capital is defined with sufficient generality, there are no added growth options.  The market value of the firm equals the market value of the operating assets broadly defined.  The reason for stressing what may seem like a pedantic distinction is to avoid double counting.  If full account is taken of all intangible assets, then there is no need to add growth options.  Put another way, the value of the firm can be thought of as equaling the value of assets in place plus the value of the growth options or the value of tangible plus intangible assets, but the two should not be mixed.
The foregoing does not imply that a division of operating market value into the value of growth options and the value of the assets in place is meritless, it simply implies that it depends entirely on the definition of “assets in place.”  If assets in place are defined broadly so as to include all intangibles of any type, then the value of the growth options is zero.  But that is not a way that assets in place are typically defined.  A more common definition is to say that the value of the assets in place equals the operating value of the firm assuming that from the current date forward it grows only at the rate of the aggregate economy.  In terms of valuation modeling, this is equivalent to assuming that the current NOPLAT represents the “terminal year” and to assume steady state growth thereafter.  In Exhibit 1, I assumed steady state growth of 5.06% based on both inflation and real growth equaling 2.5%.  I also assume that the real return on new investments in the steady state is 10.0%.  Given these assumptions, the terminal value (which by assumption equals the value of the assets in place) can be computed using the plowback formulas described by Bradley and Jarrell (2008) and Cornell and Gerger (2017).  The result, as shown in Exhibit 1, is that the value of the assets in place comes to $329 billion, leaving $388 billion as the value for growth options.  Notice that the value of the assets in place exceeds the invested capital, including intangibles, of $194 billion.  This makes sense because the intangibles not only produce the growth options but also enhance the current earning power of the invested capital as reflected in the fact that the ROIC exceeds the WACC.  It is possible, of course, to define the assets in place differently.  For example, the consulting firm Charles River Associates uses five years of analyst projections to forecast NOPLAT for next five years and assumes steady state growth thereafter.  For Alphabet, applying that procedure increases the estimated value of the assets in place and correspondingly reduces the value of the growth options.  This underscores the key point that growth options are a residual whose value depends on the procedure used to calculate the value of assets in place.

       For those of you who would like a PDF copy of the paper, including the references, please visit www.cornell-capital.com.


[1]Operating capital is defined net of cash and short-term investments.

High Expectations Can Bring Big Risks

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            The total market value of a company can be divided into two parts: the fraction of due to current and short-run foreseeable operations and everything else.  Financial economists have used the term “growth options” to describe the everything else.  Growth options are the new projects that a company will take in the long-run.  Note that many of these projects may not even be envisioned currently.  For instance, they could employ new as yet undiscovered technologies.  In the year 2000, the iPhone was such a growth option for Apple.


            The economic consulting firm, CRA, developed a simple approach for dividing a company’s stock market value into “current” operations and growth options.  The value of current operations is calculated as the sum of two parts.  The first part is the present value of projected net income over the next five years based on consensus analyst forecasts.[1]  The second part is the value of the current operations at the end of the five-year forecast period.  To calculate that value CRA assumes that from year six into perpetuity income from the then “current” operations grows at the rate of the overall economy.  Notice that this is quite a comprehensive definition of the value of current operations.  It includes all the growth expected over the next five years and continued growth along with the economy thereafter.  Finally, the value of growth options is defined as the market value equity minus the value of current operations.
 

            The CRA calculations for two contrasting companies are shown in the exhibits below during the tech boom and collapse from January of 1997 through December of 2001.  The first company is Yahoo – a poster child during the tech boom.  The exhibit shows that virtually all of the run-up, and subsequent collapse, in the price of Yahoo was due to the changing valuation of growth options.  Their value rises from close to zero in 1997 to over $200 per share at the height of the tech boom, before dropping back to about $10 at the end of 2001.  In other words, virtually all the rise and fall in the stock price was due changing expectations about future growth more than five years out, rather than changes in current operations.  In this regard, there is nothing unique about Yahoo as far as tech companies are concerned.  CRA did the same calculations for companies like Cisco, Sun, Microsoft, and eBay and the picture looked the same in every case.

 

            The situation is quite different for what are commonly called value companies.  The next exhibit below shows CRA’s calculations for Boeing.  For most of the period, virtually all the market value of Boeing is accounted for by current operations.  There is no explosion of expectations upward followed by a subsequent collapse.

 

            The warning for investors is that enthusiastic expectations regarding growth options, as opposed to current operations, can drive prices up quickly and cause them to collapse at least as fast.  Is this an issue to worry about today?  To be sure, major tech companies like Amazon and Netflix now have significant value attributable to current operations, but they also have immense market values.  So, in relative terms how important are growth options?  To provide a few illustrative examples, the exhibit below repeats the CRA calculations for Amazon, Netflix and Snap as of September 2018.  The exhibit shows that even in the fulsome way CRA defines it, current operations account for only about 30% of the market value of Amazon and Netflix and just 15% of the value of Snap.  This suggests that a change in confidence regarding growth out beyond five years could have a dramatic impact on the stock prices of these and companies whose value is even more dependent on growth options such as Shopify, Spotify, Square, Hubspot and others.




[1]CRA uses net income as an approximation for the more theoretically correct free cash flow because consensus forecasts for net income are directly available.