How Stocks Work: Four Viewpoints

I enjoyed the pieces by Felix Salmon and James Surowiecki, and Eddy Elfenbein on how stocks work.  I have reproduced their arguments here, together with my thoughts.

Felix Salmon: What’s the relationship, in theory, between a company’s return on equity, on the one hand, and its stock price, on the other? Does a high return on equity mean a rising stock price, or is it a rising return on equity which means a rising stock price? Or, to put it another way: if one company has an ROE which is (expected to be) flat at 4%, and another company has an ROE which is (expected to be) flat at 14%, would you expect the latter to rise more than the former, or indeed either of them to rise at all?

Jim Surowiecki: Your first question, unfortunately, can’t really be answered in the abstract. It’s perfectly possible for a business with high returns on capital to still be overvalued - that is, for its stock price to overestimate the cash flows it will generate over time. In that case, the fact that a company is generating high returns on capital won’t translate into an increase in its stock price. Microsoft’s average return on invested capital, for instance, is consistently good - above 25% — but its stock is just about where it was a decade ago.

This speaks to your second question, which is really about expectations. If the market is accurately forecasting the returns on capital of the low-ROIC company and the high-ROIC company, you wouldn’t expect the latter’s stock price to dramatically outperform the former. But assuming both are fairly valued, the high-ROIC company will have a much higher valuation, meaning it will generate more income for shareholders going forward (in the form of dividends, buybacks, etc.)

That’s why, all things being equal, you want to own shares of companies that generate high returns on capital rather than those of companies that don’t. This is, in a way, self-evident. If you put money into a company, you want it to use that money to generate high returns, higher than you could get elsewhere. That’s what companies that have high returns on capital do: Microsoft earns an additional twenty-five cents for every dollar it invests. By contrast, companies with low returns on capital create less value, and companies that earn returns that are lower than their cost of capital (as was true of Japanese companies between 1990 and the early part of this century) actually destroy value for their shareholders.

Eddy Elfenbein: A company’s share price is the net present value of all future cash flows. A company’s return-on-equity is a measure of profits for the next year relative to present equity, so the two are connected. However, a high ROE does not translate to a rising share price, but a rising ROE should. Regarding your question, I would assume that the market has discounted both stocks’ net present value which incorporates ROE. Therefore, I would only expect the stocks to rise at the pace of the risk-free rate plus the equity risk premium.

This may help: ROE can be broken down into three parts; profit margin, asset turnover and leverage. It goes like this:

Profit margin is earnings divided by sales. Asset turnover is sales divided by assets. Leverage is assets divided by equity.

Earnings……….Sales…………..Assets
—————X—————-X————–
Sales…………….Assets………..Equity

Note that the sales and assets cancel each other out to give you Earnings divided by Equity.

David Merkel: The question can be answered in the abstract, with some noise.  With a few assumptions/limitations as disclosed in this article, Quantitative Analysis is not Trivial — The Case of PB-ROE.  In most mature industries where capital constrains growth, there is a linear relationship between price-to-book and and ROE.    This is a result of the dividend discount model, given the assumptions of the article that I cited.

There is the inherent assumption that net worth is the limiting factor in doing new business.  If that is not the case, then the model does not work.  If sales is the limiting factors the equation becomes price-to-sales as a function of profit margins.

FS: What’s the relationship between stock price, ROE, and risk-free rate of return? Would one expect ROEs in a country with a zero risk-free rate to be lower than ROEs in a country with a higher risk-free rate? How does that feed in to stock prices, if at all?

JS: You would expect returns on invested capital to be lower in countries with lower risk-free rates (like Japan). Two reasons suggest themselves for this: first, the low risk-free rate may be indicative of lower growth prospects for the economy as a whole. But also, when the risk-free rate is low, the hurdle rate for corporate investments is also lower (because investors’ expectations of what counts as a reasonable return are also lower.) That may make companies more likely to invest in low-return projects. Both factors have something to do with why Japanese firms have underperformed over the last twenty years (and in particular in that 1990-2002 stretch). But I think the most important factors explaining the low ROIC of Japanese firms were their indifference to shareholder value and their willingness to invest in value-destroying projects.

EE: Again, a company’s share price is the net present value of all future cash flows. ROE is the best measure of the growth of future cash flows. How do we discount that? We discount it by the cost of capital which is risk-free rate plus an equity-risk premium. That’s why a lower risk-free rate tends to boost equity prices.

According to the Gordon Model, it should look something like this:

Price = Earnings/(Risk Free Rate + Equity Risk Premium - ROE)

DM: The risk free rate often has little to do with where corporations can source funds.  Eddy talks about the equity risk premium, but that varies over time.  At present that risk premium is high.  If the country in question is in a liquidity trap, like Japan, equity risk premiums are high.  In general, equity risk premiums are a free market, and disconnected from the “risk free rate” represented by short government bonds

FS: How can a company with a positive ROE destroy economic value for shareholders?

JS: The key to understanding how a company with a positive ROE can nonetheless destroy economic value is simply recognizing that equity is not free. It has a cost, just like debt does, a cost that reflects the return that investors demand as compensation for the risks and opportunity costs that owning equities entail. We can debate how to calculate that cost of equity (risk-free rate + market risk premium is a simple solution). But the basic principle is, as I said above, that a company is only creating economic value for its shareholders if it’s earning more than its cost of capital. Again, this is intuitive: if you were the part owner of a company that, on a risk-adjusted basis, was earning less than the yield you could get on a 30-year T-bill, you probably wouldn’t keep your money in that company, because you would effectively be losing money with every day that passed. Shareholders feel the same way, so the share prices of companies that earn less than their cost of capital are unlikely to rise over time. According to a study by the Japanese government, Japanese companies’ return on capital was below their cost of capital for roughly the entire decade of the 1990s through 2002. If you want to know why Japanese stock prices fell precipitously during that period, that’s the biggest reason why: the companies weren’t creating any value for shareholders. And what made it worse was that, as a result of the bubble, expectations were already inordinately high.

One thing I should say, though: Japanese companies have significantly improved their performance in the past five years, and there’s a strong case to be made that, as in the U.S., the recent sell-off of the Nikkei has been massively overdone. In fact, if you think that the transformation of Japanese firms in recent years will be long-lasting (I’m agnostic on the question), then the Nikkei looks very undervalued right now - or at least it did before it rose something like 15% in the last week and a half.

EE: All companies in all industries are in phantom competition with the cost of equity capital. Even though you can’t see it, you’re struggling against it every day. So even if a company manages to squeak out positive ROE, capital will not flow your way if you keep losing to everybody else.

DM: No disagreement here.  Companies must earn more than their cost of capital in order to add value.  This helps explain why low positive ROEs trade at a discount to book value.

=-=-=–==-=-=-=-=-=-=-=-=-=-

That’s all, and spite of all the discussion here, I own shares of  Honda Motors and the SPDR Russell/Nomura Small Cap Japan ETF.

Disclosure: long JSC, HMC

Comments

[Smarty_Pants:]

I keep thinking that some sort of estimate of inflationary rates should be included as well.

After all, you might find an investment in Zimbabwe that had ROE of 1000%. Is that better than a 10% ROE in the US?

2008 Nov 06 12:10 PM

[moonbat1775:]

Smarty,

How is this for more protection from inflation?

Use the greater of
1.) increase in money supply.
OR
2.) increase in prices.

When I think of how much brain power is spent on trying to game a dishonest system ...

2008 Nov 06 12:18 PM

[mathgeek2:]

I think the essential thinking is all here;

If markets are correctly anticipating future cash flows and the appropriate forward discount rate, then the TSR (total shareholder return, including dividends and appreciation) should be exactly equal to the risk free rate plus a market equity premium.

Of course, this is impossible in practice, and so share prices go up and down all the time (in some cases dramatically) as the market shifts its perceptions of likely future cash flows and the future path of discount rates. This can create different levels of returns for shareholders, depending on the period of time in which they held their shares.

Again, what matters is not the changes in any of these factors, but any changes relative to the expectations currently priced in the market. When I am thinking about an investmet option, one of the things I like to do is to understand the expectations (future earnings, discount rate, etc.) that appear to be implicitly priced into the stock. If I belive these expectations to be overly pessimistic, this is a buying opportunity. If the expectations are overly optimistic, this is a selling opportunity.

In fairness, there is one big problem with this methodology; While I do think it works in the longer run, in some circumstances (recent times are a great example) Market participants stop making decisions on the value of the asset and start making decision primarily on market momentum.... in other words, a version of the greater fool theory. Is my internet stock circa 1998 really worth $20? Maybe not, but I;m willing to bet someone else will buy it in a year at $40 regardless. Is my bank stock circa 2008 really worth less than the cash on the bank's books? Maybe not, but I bet I can short it today and buy it back tomorrow for half the price regardless.

When a substantial portion of the market becomes driven by players who are basically making "greater fools" bets, it is extremely difficult to know where things will go; Prices will keep going in one direction until not enough people think that there are enough greater fools left, and then they will tend to severely correct.

Only in the longer run can you expect economic reality to overwhelm these kind of issues; At some point the economcs can't be defered any longer (e.g. it becomes patently obvious to everyone that shares are over or undervalued relative to basic economics) and so the market will adjust back to a more fundamental driven prices. Of course, you can go broke waiting for that to happen...

2008 Nov 06 03:03 PM

[Alex Trias:]

The "one big problem" with your methodology (technical momentum) is actually what makes your methodology work particularly well - at least for patient investors who shun leverage. When the market is acting on fundamentals, excessive pessimism or optimism can only go so far, meaning, any excess returns you hope to achieve can only be so high. The wonders of "the greater fool" style of investing, when it dominates trading, is that you can take pessimism or optimism to far, far greater extremes, which magnifies potential excess returns on your investment. And once the momentum finally sputters out, you are left with stocks that are far cheaper than the force of pessimism alone could ever take them. From that point on, the rewards are generally handsome enough, that whether you get in too early and take a 20% hit, or too late and miss a 20% increase, doesn't end up mattering as much as you think it does during those first few months when you are buying equities and closing out short positions.

I agree with your last point, but it is less of a threat for investors who do not deploy capital in such a way as to be forced to sell assets against their will. This approach is a must for contrarian investors, who must be far more patient than quantitative traders need be (or, by the same token, can afford to be).




On Nov 06 03:03 PM User 114548 wrote:

> I think the essential thinking is all here;
>
> If markets are correctly anticipating future cash flows and the appropriate
> forward discount rate, then the TSR (total shareholder return, including
> dividends and appreciation) should be exactly equal to the risk free
> rate plus a market equity premium.
>
> Of course, this is impossible in practice, and so share prices go
> up and down all the time (in some cases dramatically) as the market
> shifts its perceptions of likely future cash flows and the future
> path of discount rates. This can create different levels of returns
> for shareholders, depending on the period of time in which they held
> their shares.
>
> Again, what matters is not the changes in any of these factors, but
> any changes relative to the expectations currently priced in the
> market. When I am thinking about an investmet option, one of the
> things I like to do is to understand the expectations (future earnings,
> discount rate, etc.) that appear to be implicitly priced into the
> stock. If I belive these expectations to be overly pessimistic, this
> is a buying opportunity. If the expectations are overly optimistic,
> this is a selling opportunity.
>
> In fairness, there is one big problem with this methodology; While
> I do think it works in the longer run, in some circumstances (recent
> times are a great example) Market participants stop making decisions
> on the value of the asset and start making decision primarily on
> market momentum.... in other words, a version of the greater fool
> theory. Is my internet stock circa 1998 really worth $20? Maybe not,
> but I;m willing to bet someone else will buy it in a year at $40
> regardless. Is my bank stock circa 2008 really worth less than the
> cash on the bank's books? Maybe not, but I bet I can short it today
> and buy it back tomorrow for half the price regardless.
>
> When a substantial portion of the market becomes driven by players
> who are basically making "greater fools" bets, it is extremely difficult
> to know where things will go; Prices will keep going in one direction
> until not enough people think that there are enough greater fools
> left, and then they will tend to severely correct.
>
> Only in the longer run can you expect economic reality to overwhelm
> these kind of issues; At some point the economcs can't be defered
> any longer (e.g. it becomes patently obvious to everyone that shares
> are over or undervalued relative to basic economics) and so the market
> will adjust back to a more fundamental driven prices. Of course,
> you can go broke waiting for that to happen...
>

2008 Nov 06 04:30 PM

[Alex Filonov:]

Future cash flows and future profits are the key numbers here. Unfortunately, they can't be predicted with any certainty. As a result, investment is a guess game, and one with better guess wins.

2008 Nov 07 02:30 PM