errata and addenda

I have a couple of what should be edits to previous posts, but I've had issues with blogspot editing in the past, so I'm going to record them here and hope that's adequate.

• About 7 weeks ago I wrote about the foreign exchange market; apparently the market has become less decentralized than I had realized.  The CME group ("Chicago Mercantile Exchange") owns a platform called EBS, and Refinitiv has a platform called Matching; these account for something like 30% of foreign exchange trading.  There are other smaller exchanges, and Cboe Global Markets ("Chicago Board Options Exchange") is launching a new market called Cboe FX Central.
  
• About 3.5 weeks ago I wrote a post with the term "Fair Value" in the title.  I sort of regret calling it that, because it's not the "Fair Value" that Warren Buffett and Benjamin Graham are talking about, even if that's what I meant to invoke.  The measure I described will have a bit of a "Fair Value" feel to a CFO, in that it calculates a value for the company independent of any price data from securities markets, and recommends that the company buy its stock if it's cheaper than that and sell if it's more expensive.  If companies reported such a thing, they really shouldn't call it "fair value", and if I'm going to allude to the term, I should give more emphasis than I did to the last two sentences of that post, which basically describe how it differs from the investor's notion of "fair value".  It's a summary statistic about internal investment opportunities that leaves to the shareholders the decision as to whether (or how much) internal investment is actually attractive; whether the stock is actually worth that amount is up to the shareholders to decide.

stock-market wealth

A lot of the people in Jane Austen novels seem to "have" an income.  I don't quite understand this; they don't seem to have jobs, exactly, and my least bad guess is that they own estates that have much more regular cash flows than I would expect manorial estates to have.  Let's suppose, though, that one "has" an income of $1 million per year, coming from such an estate.  What is the "wealth" value[1] of the estate?  Well, if comparably safe investments generally pay a 5% interest rate, a prospective buyer would be indifferent between paying $20 million for the estate versus investing that elsewhere, so the estate is worth $20 million.  If interest rates were instead 4%, the estate would be worth $25 million.

One of the things I've been hearing lately is that many billionaires have "made" billions of more dollars since March  23, or (less incorrectly) that their wealth has gone up billions of more dollars since then.  In a few cases, company profits (or prospect of future corporate profits) have gone up, but mostly they have not; since Feb  23, in fact, most company's prospects, especially in the near term, have gone down considerably.  Interest rates, however, have also gone down.  Mr. Darcy's income has gone down, but so has the income associated with any means of saving for the future, and indeed the latter has dropped sufficiently that, if Darcy were willing and able to sell his estate to someone else, he could get a higher price for it than before.

Does this mean he's richer than before?  To reiterate, other forms of saving have gone down, too; he can't take the money and put it somewhere where it will allow him to spend more on an ongoing basis.  If he has always wanted to blow all of his prospects on a bacchanal, followed by a life of penury after that, then his wealth has gone up, but if he was uninterested in selling before and is uninterested in selling now, as seems quite likely, his best allocation of his wealth over time results in a lower consumption path, not a higher one — it follows the income, not the capitalized wealth.

In what senses can we say that he is richer, or even more daringly turn the change in the capitalized value of his wealth into something like an income?  Especially for this latter step, it seems most reasonable if Darcy has been, is now, and expects to continue to be a trader, timing the market, buying low and selling high.  If he had a cash endowment at the beginning of the year, he would be better off having bought the estate in March than he would be buying it now.  If the continued value of his trading prowess is unaffected by the drop in interest rates, his ability to consume may be higher than it was before.  Conversely, it seems most obviously the case that his wealth has gone, not up, if his asset is entirely illiquid, he has no way of knowing what its capitalized value is, and he has simply been informed by his foreman that the income will be lower for the foreseeable future.

A lot of this is entailed[2] in the standard economic principle that the best measure of a person's wealth, in the long-run, is likely to be his or her level of consumption, or in any case that that's a better measure than that person's income or the total value we can assign to those of the person's tangible assets to which we can assign value.  If the stream of value that you had expected to consume is no longer one you can afford, you have gotten poorer, not richer, regardless of how that's measured in today's dollars.

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[1] We would often call this a "capitalized" value.

[2] Not in the real-estate sense of Jane Austen's world.

A simplistic guide to Fair Value for CFOs

Suppose a company can reasonably determine that if it made $300 million in new investment, its earnings (perhaps before interest and taxes) would be about 5% higher, in the long-run, than if it didn't.[1]  That basically means that the company's market cap (perhaps enterprise value) should be $6 billion[2] — independent of your cost of capital.  If you're trading at $3 billion, that means your cost of capital is high, and in fact is higher than your marginal internal rate of return; if you have cash that you're looking to deploy, you should return it to shareholders, perhaps by buying back stock.[3]  If you're trading at $10 billion, your cost of capital is lower than your marginal internal rate of return, and you should invest that $300 million internally, issuing new stock if necessary (and possible) to do so.

I've never been a CFO, and may be all wrong here, but the way schools present corporate finance the process is often sketched out as, well, you figure out your weighted average cost of capital, and your internal rate of return, and there are strategies for trying to do these things, but cost of equity in particular is pretty slippery.  And it seems to me that it frequently doesn't matter; there's a simpler approach that avoids the questions that are hard, the answers to which largely cancel out by the time you get to the part that's actionable.  So it seems to me that a lot of companies should often issue, somewhere in their quarterly or annual reports, ranges of what they think their "fair value" is, with the understanding that they're likely to buy below that range and sell above it.  If they did, I'm sure some people would misunderstand and complain, not least because so many people seem to make those two things their primary hobbies; that his has, as a side-effect, some tendency to stabilize the stock price and to make money trading the company's own stock (if you hit both ends of the range in the same period) will probably be called "manipulation" or, I don't know, "profiteering" or something — the people I have in mind aren't careful about language.  Some people might also imagine that the company is trying to tell stock traders that its price should stay in that range, which is not at all the point; certainly the company's buying and selling would not, in the face of big macroeconomic news, be expected to create hard price barriers.  The range is an indication of internal rates of return of new investment, but in a non-traditional language; if shareholders decide the demand a higher rate of return than they'd been expecting, the price of the stock can go down and the company accepts that verdict.

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[1] This is intended to be "in expectation", using a risk-neutral measure, but is still subject to supposing, for example, that you can reasonably estimate an expected glide-path that follows the otherwise expected glide-path, just some multiple higher.  I mean, you don't need the glide-paths, which is part of the point of the post; you only need the multiple.  And so I think that it's likely that there are a lot of environments in which a CFO could reasonably say that it's between 4% and 6%, in some reasonable expected sense, meaning, again, that it could end up outside that range, but that you can justify that reasonably well in the light of what should be reasonably known now.

[2] Or, continuing the previous footnote, maybe $5 billion or $7.5 billion.

[3] Ignoring other capital structure issues, which I think should be largely independent of this.