HOLT Money On The Table: How should corporate boards and executives assess idiosyncratic risk? 12 May 2015 David Holland Senior Advisor +27 76 400 9054 david.a.holland@credit-suisse.com credit-suisse.com/holtmethodology Market Commentary Summary “In theory there is no difference between theory and practice. In practice there is.” – Yogi Berra Companies should not expect to be rewarded for idiosyncratic risk Do not add fudge factors to the cost of capital to account for idiosyncratic risk Do not add fudge factors to the cost of capital to counterbalance biased forecasts Assess corporate risk tolerance and calculate the Certainty Equivalent for BIG, highly risky investments Increase enterprise value by improved risk modelling and understanding of the relationship between investment decisions, risk-bearing capacity and risk appetite CLARITY IS CONFIDENCE 1 This is market commentary and not a research document. HOLT What rate should be used to discount future cash flows? The capital asset pricing model (CAPM) is the simplest and best known approach for discounting risk. 𝑟𝑒 = 𝑟𝑓 + 𝛽 × 𝐸𝑅𝑃 The cost of equity re equals the risk-free rate rf (time-component) plus a stock-specific risk premium, β×ERP, where β is a measure of how a stock co-varies with the market, and ERP is the equity risk premium. 𝛽𝐴 = 𝜌𝐴𝑀 𝜎𝐴 𝜎𝑀 βA is the asset beta ρAM is the correlation between changes in asset and market prices σA is the volatility of the asset σM is the volatility of the market CLARITY IS CONFIDENCE 2 This is market commentary and not a research document. HOLT Companies should not expect to be rewarded for idiosyncratic risk 45% 40% Volatility 35% Corr=0 30% 25% Market 20% 15% 10% Corr=1 5% 0% 0 5 10 15 20 25 30 Number of stocks 35 40 45 50 Investors can do it themselves by owning a portfolio of stocks. You’re not helping them by doing it for them and you might be leaving money on the table. Investors want you to take risk if the expected NPV > 0. CLARITY IS CONFIDENCE 3 This is market commentary and not a research document. HOLT Connection between intrinsic value and capital budgeting decisions Goal Investors prefer more value to less. A core principle of modern finance is the net present value (NPV) rule, and that managers should aim to maximize the NPV of their firm’s present and future investments. 𝐹𝑖𝑟𝑚 𝑣𝑎𝑙𝑢𝑒 = 𝑃𝑉 𝑎𝑙𝑙 𝑓𝑢𝑡𝑢𝑟𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 = 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙0 + 𝑁𝑃𝑉𝑖 𝑃𝑟𝑜𝑗𝑒𝑐𝑡𝑠 Penalty Portfolio theory and general investment experience indicate a wonderful property of company-specific, idiosyncratic risk: it can be diversified away! Company managers should only expect to be compensated for non-diversifiable risk. Do not include arbitrary risk premiums or fudge factors in corporate hurdle rates. CLARITY IS CONFIDENCE 4 This is market commentary and not a research document. HOLT Do not add fudge factors to the cost of capital (1) Forecasts tend to be inflated by 10%, so you increase the hurdle rate by 10% and reject the project. Inputs Revenue Fudge WACC % Hurdle rate % IRR Year Revenue - Cost EBITDA - Depreciation EBIT - Tax NOPAT Results NPV at WACC NPV at Hurdle Rate 1,000 0% 13% 23% 17% Gross Fixed Assets - Depreciation Net Fixed Assets + WC Net Assets Gross Cash Flow Investment ΔWC FCF PV of FCF NPV PV of FCF (hurdle rate) NPV (hurdle rate) CLARITY IS CONFIDENCE 238 -233 0 1 1,000 -820 180 -100 80 -50 130 2 1,060 -869 191 -100 91 -53 137 3 1,124 -921 202 -100 102 -57 146 4 1,191 -977 214 -100 114 -60 154 5 1,262 -1,035 227 -100 127 -64 164 6 1,338 -1,097 241 -100 141 -67 173 7 1,419 -1,163 255 -100 155 -71 184 8 1,504 -1,233 271 -100 171 -76 195 9 1,594 -1,307 287 -100 187 -80 207 10 1,689 -1,385 304 -100 204 -85 219 1,000 1,000 -100 900 250 1,150 900 -100 800 265 1,065 800 -100 700 281 981 700 -100 600 298 898 600 -100 500 316 816 500 -100 400 335 735 400 -100 300 355 655 300 -100 200 376 576 200 -100 100 398 498 100 -100 0 0 0 230 237 246 254 264 273 284 295 307 319 -1,000 -1,000 -250 -20 -18 -15 222 174 -16 230 159 -17 238 146 -18 246 133 -19 254 122 -20 264 112 -21 274 103 -23 284 95 398 717 211 -1,000 -17 147 123 104 87 73 44 91 1,000 1,000 -1,000 238 Error compounds! 62 52 -233 5 This is market commentary and not a research document. HOLT Do not add fudge factors to the cost of capital (2) Forecasts tend to be inflated by 10%, but you only increase the hurdle rate by 5% and still reject the project. Inputs Revenue Fudge WACC % Hurdle rate % IRR Year Revenue - Cost EBITDA - Depreciation EBIT - Tax NOPAT Results NPV at WACC NPV at Hurdle Rate 1,000 0% 13% 18% 17% Gross Fixed Assets - Depreciation Net Fixed Assets + WC Net Assets Gross Cash Flow Investment ΔWC FCF PV of FCF NPV PV of FCF (hurdle rate) NPV (hurdle rate) CLARITY IS CONFIDENCE 238 -37 0 1 1,000 -820 180 -100 80 -50 130 2 1,060 -869 191 -100 91 -53 137 3 1,124 -921 202 -100 102 -57 146 4 1,191 -977 214 -100 114 -60 154 5 1,262 -1,035 227 -100 127 -64 164 6 1,338 -1,097 241 -100 141 -67 173 7 1,419 -1,163 255 -100 155 -71 184 8 1,504 -1,233 271 -100 171 -76 195 9 1,594 -1,307 287 -100 187 -80 207 10 1,689 -1,385 304 -100 204 -85 219 1,000 1,000 -100 900 250 1,150 900 -100 800 265 1,065 800 -100 700 281 981 700 -100 600 298 898 600 -100 500 316 816 500 -100 400 335 735 400 -100 300 355 655 300 -100 200 376 576 200 -100 100 398 498 100 -100 0 0 0 230 237 246 254 264 273 284 295 307 319 -1,000 -1,000 -250 -20 -18 -15 222 174 -16 230 159 -17 238 146 -18 246 133 -19 254 122 -20 264 112 -21 274 103 -23 284 95 398 717 211 -1,000 -17 160 140 123 107 94 64 137 1,000 1,000 -1,000 238 Error compounds! 83 73 -37 6 This is market commentary and not a research document. HOLT Improvised hurdle rates don’t save money, they distort capital budgeting If forecasts tend to be inflated by 10%, you should de-bias them by 10%. Hurdle rate errors compound. The only remedy is to de-bias and improve forecasts. Inputs Revenue Fudge WACC % Hurdle rate % IRR Year Revenue - Cost EBITDA - Depreciation EBIT - Tax NOPAT Results NPV at WACC NPV at Hurdle Rate 1,000 -10% 13% 23% 16% Gross Fixed Assets - Depreciation Net Fixed Assets + WC Net Assets Gross Cash Flow Investment ΔWC FCF PV of FCF NPV 168 0 1 900 -738 162 -100 62 -45 117 2 954 -782 172 -100 72 -48 124 3 1,011 -829 182 -100 82 -51 131 4 1,072 -879 193 -100 93 -54 139 5 1,136 -932 205 -100 105 -57 147 6 1,204 -988 217 -100 117 -61 156 7 1,277 -1,047 230 -100 130 -64 165 8 1,353 -1,110 244 -100 144 -68 175 9 1,434 -1,176 258 -100 158 -72 186 10 1,521 -1,247 274 -100 174 -77 197 1,000 1,000 -100 900 225 1,125 900 -100 800 239 1,039 800 -100 700 253 953 700 -100 600 268 868 600 -100 500 284 784 500 -100 400 301 701 400 -100 300 319 619 300 -100 200 338 538 200 -100 100 359 459 100 -100 0 0 0 217 224 231 239 247 256 265 275 286 297 -225 -8 -7 -14 210 165 -14 217 150 -15 224 137 -16 231 125 -17 239 115 -18 247 105 -19 256 96 -20 266 88 359 656 193 1,000 1,000 -1,000 -1,000 -1,000 168 The de-biasing factor should actually be -9.09% in this case, i.e., 1/1.10 - 1 = -9.09% CLARITY IS CONFIDENCE 7 This is market commentary and not a research document. HOLT How can idiosyncratic risk be assessed and managed? Risk dilemma The risk premium for diversifiable risk is zero. This point is too often forgotten when evaluating investments. The addition of arbitrary risk premiums to conjure hurdle rates might turn value creating projects into value destroying projects that get rejected. It can also lead to fallacious forecasts meant to counter unjustifiably high hurdle rates, thus subverting the entire capital allocation exercise. Money is often left on the table. Risk tolerance can help Assess a company’s risk tolerance and incorporate it into a utility function: 𝑢 𝑥 =1− 𝑥 −𝑅 𝑒 Risk tolerance (R) is a preference and reflects an individual’s risk aversion, while x is the specific dollar value of interest. CLARITY IS CONFIDENCE 8 This is market commentary and not a research document. HOLT Calculate Certainty Equivalent (CE) using PrecisionTree Certainty equivalent for bet #1 Would you take this bet if your risk tolerance were R10,000? Payoff of 2X TRUE Invest X -8 000 75% 75% 16 000 8 000 EV 4 000 Payoff of zero 25% 0 25% -8 000 EV Invest in venture? 4 000 Invest nothing FALSE 0 0% 0 Certainty equivalent for bet #2 Would you take this bet if your risk tolerance were R10,000? Payoff of 2X 75% 24 000 TRUE Invest X -12 000 EV 6 000 Payoff of zero 25% 0 Invest in venture? 75% 12 000 25% -12 000 EV 6 000 Invest nothing FALSE 0 CLARITY IS CONFIDENCE 0% 0 9 This is market commentary and not a research document. HOLT WhizKidz has a potential project called “Showtime” About WhizKidz WhizKidz is a toy manufacturer with a market cap of $10bn and beta of one, i.e., its fortunes tend to track those of the market. It has $2bn in cash and a chance to invest it in a project with a present value of $3bn resulting in an NPV of $1bn. Should WhizKidz proceed? Two scenarios Let’s assume two scenarios for the introduction of a product “Showtime”. It has a 50% chance of being a success and generating an NPV of $2bn (PV = $4bn), and a 50% chance of breaking even with NPV of $0 (PV = $2bn). The expected NPV, E[NPV], is $1bn and there is no reason not to proceed unless management is irrationally riskaverse. If it rejected the investment and the market realized the decision was irrational, we would expect to see shareholder activists, private equity investors and competitors express keen interest in shaking up the board or taking over the firm. 𝐸 𝑁𝑃𝑉 = 0.50 × $4𝑏𝑛 + 0.50 × $2𝑏𝑛 − $2𝑏𝑛 = $1𝑏𝑛 CLARITY IS CONFIDENCE 10 This is market commentary and not a research document. HOLT WhizKidz has another potential project called “Blockbuster” Let’s make the problem more interesting by making it an absolute blockbuster with a present value of $6bn or a total failure with a present value of nil. 𝐸 𝑁𝑃𝑉 = 0.50 × $6𝑏𝑛 + 0.50 × $0 − $2𝑏𝑛 = $1𝑏𝑛 The expected value remains $1bn but the standard deviation jumps to $3bn. The blockbuster project is 3 times riskier than the first project. Summary • Both projects have a NPV of $1bn • “Showtime” has a standard deviation of ±$1bn and “Blockbuster” ±$3bn • A rational manager would choose “Showtime” if they were mutually exclusive • Is there a single magical number we can calculate for each project? CLARITY IS CONFIDENCE 11 This is market commentary and not a research document. HOLT Calculate the Certainty Equivalent Certainty equivalent for “Showtime” (1) Expected value of $1bn and CE of $760m if risk tolerance is $2bn Success TRUE Invest 50% 50% 4 000 2 000 Success EV -2 000 50% Failure 2 000 Failure 50% 2 000 50% 50% 2 000 0 0 CE Invest in project 1? 760 1 000 Invest nothing CE 760 50% EV Invest in project 1? TRUE -2 000 Invest 1 000 50% 4 000 FALSE 0% 0 FALSE Invest nothing 0% 0 0 0 Certainty equivalent for “Blockbuster” (2) Expected value of $1bn and CE of ($711m) if risk tolerance is $2bn Success TRUE Invest 50% 50% 6 000 4 000 Invest 1 000 50% Failure 0 Invest in project 2? 6 000 EV -2 000 CE -711 50% 50% Failure 0 EV Invest in project 2? 0% 4 000 0% -2 000 CE 0 FALSE 0 CLARITY IS CONFIDENCE FALSE -2 000 -2 000 1 000 Invest nothing 50% Success 0% Invest nothing TRUE 0 0 12 This is market commentary and not a research document. 100% 0 HOLT How sensitive is CE to changes in probability and risk tolerance? 1 000 100 000 90 000 80 000 70 000 60 000 50 000 40 000 30 000 20 000 -500 10 000 0 0 CE ($'m) 500 -1 000 -1 500 -2 000 Risk tolerance ($'m) Relationship between CE and p(success) • EV = CE when uncertainty is zero • From CE perspective, “Blockbuster” becomes attractive if p(success) > 65% • From risk neutral perspective, the project is attractive if p(success) > 33% CLARITY IS CONFIDENCE Relationship between CE & risk tolerance • CE ≈ EV if value <<< risk tolerance • CE > 0 if risk tolerance > $4bn for “Blockbuster” • Risk can be shared with other parties and apportioned according to risk tolerance 13 This is market commentary and not a research document. HOLT Risk Appetite, Risk Bearing Capacity and Enterprise Value Risk-bearing Capacity (able) High Leaving Money on the Table Diamond Limited willingness to pursue upside of good risk management Significant strategic ambition and plans, coupled with ability to execute Material chance of underperformance due to lazy corporate balance sheet (higher investment risk premium) Strong potential for large rewards with reduced uncertainty if well aligned Safe in the Harbour Irrational Exuberance Limited strategic growth ambition, but commensurate with ability to execute on the associated plans. Strategic ambition but inadequate ability to support risk. High potential for overextension or catastrophic event (higher equity risk premium or have to get lucky) Strong chance of financial and share price underperformance. Low Low MARSH RISK CONSULTING Source: Marsh Risk Consulting Risk Appetite (willing) High Market-implied real discount rate for listed South African non-Financials CLARITY IS CONFIDENCE This is market commentary and not a research document. HOLT Summary “In theory there is no difference between theory and practice. In practice there is.” – Yogi Berra Companies should not expect to be rewarded for idiosyncratic risk Do not add fudge factors to the cost of capital to account for idiosyncratic risk Do not add fudge factors to the cost of capital to counterbalance biased forecasts Assess corporate risk tolerance and calculate the Certainty Equivalent for BIG, highly risky investments Increase enterprise value by improved risk modelling and understanding of the relationship between investment decisions, risk-bearing capacity and risk appetite CLARITY IS CONFIDENCE 16 This is market commentary and not a research document. 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HOLT is a corporate performance and valuation advisory service of Credit Suisse. © 2015 Credit Suisse Group AG and its subsidiaries and affiliates. All rights reserved. For region specific disclosures, including information about applicable registrations and certain regulatory disclosures, please follow the links below: Americas: https://www.credit-suisse.com/legal/en/ib/market_commentary.jsp Europe: https://www.credit-suisse.com/legal/en/ib/europe.jsp (Credit Suisse Securities (Europe) Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority in the United Kingdom) Asia: https://www.credit-suisse.com/legal/en/ib/market_commentary_disclaimer_asia.jsp General investors in Japan should open the following link and read it: https://www.credit-suisse.com/jp/investment_banking/ja/disclaimer/ CLARITY IS CONFIDENCE 17 This is market commentary and not a research document. HOLT