Understanding the Debt Downgrade: A Fundamental Approach

As I try to understand the debt downgrade and how it will effect the equities markets, I find myself relying on a piece of advice from my valuation professor. “When new information comes to light”, the professor said, “ask yourself: what lever of the ‘value’ formula is being affected?” More specifically, the professor was referring to the perpetuity discounted cash flow (DCF) formula, which is:

Value = Cash Flow / (Cost of Capital – Growth Rate of Cash Flows).

The levers are the cash flows generated by the company, the growth rate of those cash flows, and the opportunity cost of capital, i.e. the minimum return acceptable to investors. The purpose of the formula is to discount future cash flows into a net present value. The formula is not perfect, mainly because it assumes constant growth in cash flows, but it is an excellent rule of thumb. If you’re familiar with finance, this is not new and you can probably stop reading. If finance is not your thing, stick with me – you’ll soon understand, I hope.

So, what is the key lever being affected by S&P downgrade? It is the cost of capital. The downgrade is a signal that a default is more likely than previously thought. The greater the risk of default, the greater the return required by investors to compensate them for that risk. Of course, this is not cut and dry. US debt investors may have already priced in the riskiness of default, which means treasuries may not swing as widely on the news. Also, if sovereign debt of other nations (like the EU or Japan) is more risky than US debt, than the US is still a “safe haven” and the large pool of buyers will keep prices high and rates low. But for the sake of understanding the fundamentals of the downgrade, lets assume that treasury rates rise. Since the cost of capital sits in the denominator of the value formula, an increase results in a decline in value. Put simply, a rise in the cost of capital with everything else remaining constant results in a lower valuation or stock price.

Let’s go one step further and explain how a rise in treasury rates affect the cost of capital of a company. For simplicity purposes, I’m assuming the company is equity-financed, meaning that it does not have any debt.

I need to introduce one more formula: The Capital Asset Pricing Model (CAPM).

CAPM = risk free rate + beta * (market risk premium)

The risk free rate is, well, the treasury rate. Beta, without getting too deep in the weeds, is the riskiness of a particular stock. And the market risk premium is the amount above the risk free rate investors expect to earn by investing in the equities market. If beta and the market risk premium remain constant, than a rise in the risk free rate — i.e. the treasury rate — results in a higher cost of capital.

To put this all together, I have created an example. Let’s assume a company has an equity beta of 1.1, which means that if the entire market rises the company’s stock will increase too, but at a slightly higher rate. And vice versa: if the market falls, the stock will fall slightly more than the wider market. The risk free rate is the ten-year treasury rate which just last week was around 2.6%. The market risk premium is 4%, meaning that if treasuries are 2.6% than the expected return from investing in stocks in 6.6% (2.6% plus 4%). Thus, CAPM equals:

CAPM = 7% = 2.6% + (1.1* 4%)

So now that we have our cost of capital of 7%, let’s look at the value of the company.  Assume that the company is generating $100 of cash flow and that those cash flows will grow at the inflation rate, about 3%. Thus the discounted value of the company is:

DCF = $2,500 = $100 / (7% – 3%)

Now let’s look at what happens if all else remains constant but the treasury rate increases to, say, 3.5%. At this rate the cost of capital is:

CAPM = 7.9% = 3.5% + (1.1*4%)

And the value of the company falls to:

DCF = $2,041 = $100 / (7.9% – 3%).

In short, a 0.90% increase in the treasury rate will cause the value of our hypothetical company to fall 18%. To get a better picture, I have published a Google Spreadsheet.

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I Told the World How Smart I Am. Will you?

This morning I updated my About Me section with my Smarterer Excel score.  If you’re not familiar, Smarterer is a Boston-based start-up that offers a variety of technical skills tests, such as Google Search, Photoshop, Foursquare, Python – you name it. The tests are multiple choice and employ an adaptive rating system; this approach allows Smarterer to assess test-takers in only a few minutes. Upon completion, test-takers can see how they compare to others in the community, and also post their Smarterer score “badges” on other sites. The product is currently in beta.

Overall, I am a fan. Smarterer is solving the asymmetrical information problem plaguing both hiring managers and job seekers. Hiring managers no longer need to guess a candidate’s skill level based on a vague resume bullet point. On the flip side, candidates do not need to fear that their skills will be overshadowed by other candidates that exaggerate. In short, Smarterer provides a measuring stick that both companies and candidates benefit by using. Also, I like Smarterer’s approach. All tests are crowd-sourced which will enable the company to scale quickly and stay abreast of new technologies.

As with any beta, Smarterer tests have a few flaws. First, the crowd-sourced, multiple-author approach — while the right approach — results in inconsistencies between questions. For example, one question on the Excel test was so long-winded that it did not fit on the screen, so I was left scrolling up and down reading between choice A and D. Eventually, time ran out and I got the question wrong. Also, some questions do not lend themselves to multiple choice answers; for example, one question asked about cutting and pasting a cell where the row and column are locked with the “$” symbol. This is an easy question to visualize but in the multiple choice world it is basically an exercise in alphabetizing.

Smarterer’s success depends on test-takers posting their scores across the digital expanse. The more ubiquitous badges become, the greater the value of the measuring stick. This is true of any standard system. An SAT score or NYC Restaurant Grade means nothing if only a handful of applicants or establishments possess them.

Typically, standards are driven by the consumer. The consumers of SAT scores are colleges, so it is no surprise that the test is administered by a non-profit consortium of colleges. The birthplace of standards, the steel industry, was also driven by the consumer: the railroad companies buying steel to lay tracks. Given this logic and assuming that the overall consumer of Smarterer scores are employers, people will not take the test and post their scores until they are required to by potential employers.

But perhaps this is an outdated, pre-social network view. All day, every day people exhibit their intelligence, wits, tastes, physical prowess and sense of humor simply because they can. Twitter, Foursquare, IntoNow, RunKeeper are just a few examples. People are naturally motivated – and increasingly getting comfortable with – outright displays of emotions, thoughts and talents.

What will motivate you to share your score? Will you only take the test and share your score in order to land your next job? Or will you share your score because you want the world to know just a little bit more about you? Please let me know your thoughts. If you don’t want to use the comments section, please email me directly.