The Bondholders Defense Against Stockholder Excessespeople.stern.nyu.edu/adamodar/podcasts/cfUGspr16/Session5.pdf · ¨ More restric9ve covenants on investment, financing and dividend

61

TheBondholders’DefenseAgainstStockholderExcesses

AswathDamodaran

61

¨  Morerestric9vecovenantsoninvestment,financinganddividendpolicyhavebeenincorporatedintobothprivatelendingagreementsandintobondissues,topreventfuture“Nabiscos”.

¨  Newtypesofbondshavebeencreatedtoexplicitlyprotectbondholdersagainstsuddenincreasesinleverageorotherac9onsthatincreaselenderrisksubstan9ally.Twoexamplesofsuchbonds¤  PuFableBonds,wherethebondholdercanputthebondbacktothefirm

andgetfacevalue,ifthefirmtakesac9onsthathurtbondholders¤  Ra9ngsSensi9veNotes,wheretheinterestrateonthenotesadjuststo

thatappropriateforthera9ngofthefirm¨  Morehybridbonds(withanequitycomponent,usuallyintheform

ofaconversionop9onorwarrant)havebeenused.Thisallowsbondholderstobecomeequityinvestors,iftheyfeelitisintheirbestintereststodoso.

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TheFinancialMarketResponse

AswathDamodaran

62

¨  Whileanalystsaremorelikelys9lltoissuebuyratherthansellrecommenda9ons,thepayofftouncoveringnega9venewsaboutafirmislargeenoughthatsuchnewsiseagerlysoughtandquicklyrevealed(atleasttoalimitedgroupofinvestors).

¨  Asinvestoraccesstoinforma9onimproves,itisbecomingmuchmoredifficultforfirmstocontrolwhenandhowinforma9ongetsouttomarkets.

¨  Asop9ontradinghasbecomemorecommon,ithasbecomemucheasiertotradeonbadnews.Intheprocess,itisrevealedtotherestofthemarket.

¨  Whenfirmsmisleadmarkets,thepunishmentisnotonlyquickbutitissavage.

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TheSocietalResponse

AswathDamodaran

63

¨  Iffirmsconsistentlyfloutsocietalnormsandcreatelargesocialcosts,thegovernmentalresponse(especiallyinademocracy)isforlawsandregula9onstobepassedagainstsuchbehavior.

¨  Forfirmscateringtoamoresociallyconsciousclientele,thefailuretomeetsocietalnorms(evenifitislegal)canleadtolossofbusinessandvalue.

¨  Finally,investorsmaychoosenottoinvestinstocksoffirmsthattheyviewassociallyirresponsible.

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TheCounterReac9on

AswathDamodaran

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STOCKHOLDERS

Managers of poorly run firms are puton notice.

1. More activistinvestors2. Hostile takeovers

BONDHOLDERSProtect themselves

1. Covenants2. New Types

FINANCIAL MARKETS

SOCIETYManagers

Firms arepunishedfor misleadingmarkets

Investors andanalysts becomemore skeptical

Corporate Good Citizen Constraints

1. More laws2. Investor/Customer Backlash

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Sowhatdoyouthink?

AswathDamodaran

65

¨  Atthispointin9me,thefollowingstatementbestdescribeswhereIstandintermsoftherightobjec9vefunc9onfordecisionmakinginabusinessa.  Maximizestockprice,withnoconstraintsb.  Maximizestockprice,withconstraintsonbeingagoodsocialci9zen.c.  Maximizestockholderwealth,withgoodci9zenconstraints,and

hope/praythatthemarketcatchesupwithyou.d.  Maximizeprofitsorprofitabilitye.  Maximizeearningsgrowthf.  Maximizemarketshareg.  Maximizerevenuesh.  Maximizesocialgoodi.  Noneoftheabove

66

TheModifiedObjec9veFunc9on

AswathDamodaran

66

¨  Forpubliclytradedfirmsinreasonablyefficientmarkets,wherebondholders(lenders)areprotected:¤  MaximizeStockPrice:Thiswillalsomaximizefirmvalue

¨  Forpubliclytradedfirmsininefficientmarkets,wherebondholdersareprotected:¤  Maximizestockholderwealth:Thiswillalsomaximizefirmvalue,butmightnotmaximizethestockprice

¨  Forpubliclytradedfirmsininefficientmarkets,wherebondholdersarenotfullyprotected¤  Maximizefirmvalue,thoughstockholderwealthandstockpricesmaynotbemaximizedatthesamepoint.

¨  Forprivatefirms,maximizestockholderwealth(iflendersareprotected)orfirmvalue(iftheyarenot)

THEINVESTMENTPRINCIPLE:RISKANDRETURNMODELS“YoucannotswinguponaropethatisaFachedonlytoyourownbelt.”

AswathDamodaran 67

68

FirstPrinciples

AswathDamodaran

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69

Theno9onofabenchmark

AswathDamodaran

69

¨  Sincefinancialresourcesarefinite,thereisahurdlethatprojectshavetocrossbeforebeingdeemedacceptable.Thishurdleshouldbehigherforriskierprojectsthanforsaferprojects.

¨  Asimplerepresenta9onofthehurdlerateisasfollows:Hurdlerate= RisklessRate+RiskPremium

¨  Thetwobasicques9onsthateveryriskandreturnmodelinfinancetriestoanswerare:¤  Howdoyoumeasurerisk?¤  Howdoyoutranslatethisriskmeasureintoariskpremium?

70

WhatisRisk?

AswathDamodaran

70

¨  Risk,intradi9onalterms,isviewedasa‘nega9ve’.Webster’sdic9onary,forinstance,definesriskas“exposingtodangerorhazard”.TheChinesesymbolsforrisk,reproducedbelow,giveamuchbeFerdescrip9onofrisk

危机¨  Thefirstsymbolisthesymbolfor“danger”,whilethesecond

isthesymbolfor“opportunity”,makingriskamixofdangerandopportunity.Youcannothaveone,withouttheother.

¨  Riskisthereforeneithergoodnorbad.Itisjustafactoflife.Theques9onthatbusinesseshavetoaddressisthereforenotwhethertoavoidriskbuthowbesttoincorporateitintotheirdecisionmaking.

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Agoodriskandreturnmodelshould…

AswathDamodaran

71

1.  Itshouldcomeupwithameasureofriskthatappliestoallassetsandnotbeasset-specific.

2.  Itshouldclearlydelineatewhattypesofriskarerewardedandwhatarenot,andprovideara9onaleforthedelinea9on.

3.  Itshouldcomeupwithstandardizedriskmeasures,i.e.,aninvestorpresentedwithariskmeasureforanindividualassetshouldbeabletodrawconclusionsaboutwhethertheassetisabove-averageorbelow-averagerisk.

4.  Itshouldtranslatethemeasureofriskintoarateofreturnthattheinvestorshoulddemandascompensa9onforbearingtherisk.

5.  Itshouldworkwellnotonlyatexplainingpastreturns,butalsoinpredic9ngfutureexpectedreturns.

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TheCapitalAssetPricingModel

AswathDamodaran

72

1.  Usesvarianceofactualreturnsaroundanexpectedreturnasameasureofrisk.

2.  Specifiesthatapor9onofvariancecanbediversifiedaway,andthatisonlythenon-diversifiablepor9onthatisrewarded.

3.  Measuresthenon-diversifiableriskwithbeta,whichisstandardizedaroundone.

4.  Translatesbetaintoexpectedreturn-ExpectedReturn=Riskfreerate+Beta*RiskPremium

5.  Worksaswellasthenextbestalterna9veinmostcases.

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1.TheMean-VarianceFramework

AswathDamodaran

73

¨  Thevarianceonanyinvestmentmeasuresthedisparitybetweenactualandexpectedreturns.

Expected Return

Low Variance Investment

High Variance Investment

74

HowriskyisDisney?Alookatthepast…

AswathDamodaran

74

-25.00%

-20.00%

-15.00%

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

Oct-08

Dec-08

Feb-09

Apr-09

Jun-09

Aug-09

Oct-09

Dec-09

Feb-10

Apr-10

Jun-10

Aug-10

Oct-10

Dec-10

Feb-11

Apr-11

Jun-11

Aug-11

Oct-11

Dec-11

Feb-12

Apr-12

Jun-12

Aug-12

Oct-12

Dec-12

Feb-13

Apr-13

Jun-13

Aug-13

ReturnsonDisney-2008-2013Averagemonthlyreturn=1.65%Averagemonthlystandarddevia9on=7.64%Averageannualreturn=21.70%Averageannualstandarddevia9on=26.47%

75

Doyouliveinamean-varianceworld?

AswathDamodaran

75

¨  Assumethatyouhadtopickbetweentwoinvestments.Theyhavethesameexpectedreturnof15%andthesamestandarddevia9onof25%;however,investmentAoffersaverysmallpossibilitythatyoucouldquadrupleyourmoney,whileinvestmentB’shighestpossiblepayoffisa60%return.Wouldyoua.  beindifferentbetweenthetwoinvestments,sincetheyhavethe

sameexpectedreturnandstandarddevia9on?b.  preferinvestmentA,becauseofthepossibilityofahighpayoff?b.  preferinvestmentB,becauseitissafer?

¨  Wouldyouranswerchangeifyouwerenottoldthatthereisasmallpossibilitythatyoucouldlose100%ofyourmoneyoninvestmentAbutthatyourworstcasescenariowithinvestmentBis-50%?

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TheImportanceofDiversifica9on:RiskTypes

AswathDamodaran

76

Actions/Risk that affect only one firm

Actions/Risk that affect all investments

Firm-specific Market

Projects maydo better orworse thanexpected

Competitionmay be strongeror weaker thananticipated

Entire Sectormay be affectedby action

Exchange rateand Politicalrisk

Interest rate,Inflation & news about economy

Figure 3.5: A Break Down of Risk

Affects fewfirms

Affects manyfirms

Firm can reduce by

Investing in lots of projects

Acquiring competitors

Diversifying across sectors

Diversifying across countries

Cannot affect

Investors can mitigate by

Diversifying across domestic stocks Diversifying across asset classes

Diversifying globally

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Whydiversifica9onreduces/eliminatesfirmspecificrisk

AswathDamodaran

77

¨  Firm-specificriskcanbereduced,ifnoteliminated,byincreasingthenumberofinvestmentsinyourporpolio(i.e.,bybeingdiversified).Market-wideriskcannot.Thiscanbejus9fiedoneithereconomicorsta9s9calgrounds.

¨  Oneconomicgrounds,diversifyingandholdingalargerporpolioeliminatesfirm-specificriskfortworeasons-a.  Eachinvestmentisamuchsmallerpercentageoftheporpolio,

mu9ngtheeffect(posi9veornega9ve)ontheoverallporpolio.

b.  Firm-specificac9onscanbeeitherposi9veornega9ve.Inalargeporpolio,itisargued,theseeffectswillaverageouttozero.(Foreveryfirm,wheresomethingbadhappens,therewillbesomeotherfirm,wheresomethinggoodhappens.)

78

TheRoleoftheMarginalInvestor

AswathDamodaran

78

¨  Themarginalinvestorinafirmistheinvestorwhoismostlikelytobethebuyerorselleronthenexttradeandtoinfluencethestockprice.

¨  Generallyspeaking,themarginalinvestorinastockhastoownalotofstockandalsotradethatstockonaregularbasis.

¨  Sincetradingisrequired,thelargestinvestormaynotbethemarginalinvestor,especiallyifheorsheisafounder/managerofthefirm(LarryEllisonatOracle,MarkZuckerbergatFacebook)

¨  Inallriskandreturnmodelsinfinance,weassumethatthemarginalinvestoriswelldiversified.

79

Iden9fyingtheMarginalInvestorinyourfirm…

AswathDamodaran

79

Percent of Stock held

by Institutions

Percent of Stock held by

Insiders

Marginal Investor

High Low Institutional Investor

High High Institutional Investor, with insider influence

Low High (held by

founder/manager of firm)

Tough to tell; Could be insiders but only if they

trade. If not, it could be individual investors.

Low High (held by wealthy

individual investor)

Wealthy individual investor, fairly diversified

Low Low Small individual investor with restricted

diversification

80

Gaugingthemarginalinvestor:Disneyin2013

Aswath Damodaran

81

Extendingtheassessmentoftheinvestorbase

¨  Inallfiveofthepubliclytradedcompaniesthatwearelookingat,ins9tu9onsarebigholdersofthecompany’sstock.

Aswath Damodaran

82

TheLimi9ngCase:TheMarketPorpolio

AswathDamodaran

82

¨  Thebigassump9ons&thefollowup:Assumingdiversifica9oncostsnothing(intermsoftransac9onscosts),andthatallassetscanbetraded,thelimitofdiversifica9onistoholdaporpolioofeverysingleassetintheeconomy(inpropor9ontomarketvalue).Thisporpolioiscalledthemarketporpolio.

¨  Theconsequence:Individualinvestorswilladjustforrisk,byadjus9ngtheiralloca9onstothismarketporpolioandarisklessasset(suchasaT-Bill):Preferredrisklevel Alloca?ondecisionNorisk 100%inT-BillsSomerisk 50%inT-Bills;50%inMarketPorpolio;AliFlemorerisk 25%inT-Bills;75%inMarketPorpolioEvenmorerisk 100%inMarketPorpolioAriskhog.. Borrowmoney;Investinmarketporpolio

83

TheRiskofanIndividualAsset

AswathDamodaran

83

¨  Theessence:TheriskofanyassetistheriskthatitaddstothemarketporpolioSta9s9cally,thisriskcanbemeasuredbyhowmuchanassetmoveswiththemarket(calledthecovariance)

¨  Themeasure:Betaisastandardizedmeasureofthiscovariance,obtainedbydividingthecovarianceofanyassetwiththemarketbythevarianceofthemarket.Itisameasureofthenon-diversifiableriskforanyassetcanbemeasuredbythecovarianceofitsreturnswithreturnsonamarketindex,whichisdefinedtobetheasset'sbeta.

¨  Theresult:Therequiredreturnonaninvestmentwillbealinearfunc9onofitsbeta:¤  ExpectedReturn=RiskfreeRate+Beta*(ExpectedReturnonthe

MarketPorpolio-RiskfreeRate)

84

Limita9onsoftheCAPM

AswathDamodaran

84

1.Themodelmakesunrealis9cassump9ons2.Theparametersofthemodelcannotbees9matedprecisely

¤  Themarketindexusedcanbewrong.¤  Thefirmmayhavechangedduringthe'es9ma9on'period'

3.Themodeldoesnotworkwell¤  -Ifthemodelisright,thereshouldbe:

n  Alinearrela9onshipbetweenreturnsandbetasn  Theonlyvariablethatshouldexplainreturnsisbetas

¤  -Therealityisthatn  Therela9onshipbetweenbetasandreturnsisweakn  Othervariables(size,price/bookvalue)seemtoexplaindifferencesinreturnsbeFer.

85

Alterna9vestotheCAPM

AswathDamodaran

85

The risk in an investment can be measured by the variance in actual returns around an expected return

E(R)

Riskless Investment Low Risk Investment High Risk Investment

E(R) E(R)

Risk that is specific to investment (Firm Specific) Risk that affects all investments (Market Risk)Can be diversified away in a diversified portfolio Cannot be diversified away since most assets1. each investment is a small proportion of portfolio are affected by it.2. risk averages out across investments in portfolioThe marginal investor is assumed to hold a “diversified” portfolio. Thus, only market risk will be rewarded and priced.

The CAPM The APM Multi-Factor Models Proxy ModelsIf there is 1. no private information2. no transactions costthe optimal diversified portfolio includes everytraded asset. Everyonewill hold this market portfolioMarket Risk = Risk added by any investment to the market portfolio:

If there are no arbitrage opportunities then the market risk ofany asset must be captured by betas relative to factors that affect all investments.Market Risk = Risk exposures of any asset to market factors

Beta of asset relative toMarket portfolio (froma regression)

Betas of asset relativeto unspecified marketfactors (from a factoranalysis)

Since market risk affectsmost or all investments,it must come from macro economic factors.Market Risk = Risk exposures of any asset to macro economic factors.

Betas of assets relativeto specified macroeconomic factors (froma regression)

In an efficient market,differences in returnsacross long periods mustbe due to market riskdifferences. Looking forvariables correlated withreturns should then give us proxies for this risk.Market Risk = Captured by the Proxy Variable(s)

Equation relating returns to proxy variables (from aregression)

Step 1: Defining Risk

Step 2: Differentiating between Rewarded and Unrewarded Risk

Step 3: Measuring Market Risk

86

WhytheCAPMpersists…

AswathDamodaran

86

¨  TheCAPM,notwithstandingitsmanycri9csandlimita9ons,hassurvivedasthedefaultmodelforriskinequityvalua9onandcorporatefinance.Thealterna9vemodelsthathavebeenpresentedasbeFermodels(APM,Mul9factormodel..)havemadeinroadsinperformanceevalua9onbutnotinprospec9veanalysisbecause:¤  Thealterna9vemodels(whicharericher)doamuchbeFerjobthan

theCAPMinexplainingpastreturn,buttheireffec9venessdropsoffwhenitcomestoes9ma9ngexpectedfuturereturns(becausethemodelstendtoshivandchange).

¤  Thealterna9vemodelsaremorecomplicatedandrequiremoreinforma9onthantheCAPM.

¤  Formostcompanies,theexpectedreturnsyougetwiththethealterna9vemodelsisnotdifferentenoughtobeworththeextratroubleofes9ma9ngfouraddi9onalbetas.

87

Applica9onTest:Whoisthemarginalinvestorinyourfirm?

AswathDamodaran

87

¨  Youcangetinforma9ononinsiderandins9tu9onalholdingsinyourfirmfrom:¤  hFp://finance.yahoo.com/¤  Enteryourcompany’ssymbolandchooseprofile.

¨  Lookingatthebreakdownofstockholdersinyourfirm,considerwhetherthemarginalinvestoris¤  Anins9tu9onalinvestor¤  Anindividualinvestor¤  Aninsider