Go Big- The Macro Story
The most important aspect in this chapter is the process explanation to segregate corporate stories into macro and micro parts.
There are many companies that are cyclical or are dependent on commodity prices or the country level risk. Therefore, their valuation is as much dependent upon the commodity prices or economic scenario (external factors – macro) rather than the fundamentals (internal factors – micro). However, it is prudent to believe that not everyone is proficient in estimating commodity prices or market cycles to predict the booms and recessions.
Therefore, the professor has advised us to separate these vertices. How? Let’s take an example.
Suppose we are valuing Exxon Mobil. It’s an oil exploration company and therefore is dependent upon crude oil prices. So, can I just base the investment decision on the expectation of crude oil prices? If that was the case, then why can’t I just buy crude oil futures. This means that for buying into ExxonMobil, there are company level factors like management strength, efficiency, cost of production, corporate governance, etc. which also affects the company’s valuation. Hence the professor advises to take out two step valuations.
- Value the company as per the average crude oil price during the period under consideration. For example, the price of crude oil as of March 2009 is $45 per barrel. However, the latest available financial data for the company was as of December 2008. The price of crude oil during the twelve-month period ending December 2008 was $86.55 per barrel. As the operating profit depends heavily on crude oil prices, hence a lower crude oil price indicates a lower profit in the coming year. Therefore, as a base estimate, we take out what the operating profit would be when the oil price was $45 per barrel. This can be taken out via the regression analysis, wherein we derive a formula based on the historical relation of the company’s profit and crude oil prices. The calculated number was $34.61 bn. Valuing the company on the basis of 2% perpetual growth rate and a 8.18% cost of capital, gave a value of operating asset at $342.5bn or $69.43 per share. At the CMP of $64.83 ( as of Mar 2009), the stock seemed undervalued. This is based on the expectation that normalized oil price will be $45.
- Now, since the profitability depends heavily on crude oil prices, let's estimate the crude oil price for the next year. This is done via simulation, wherein probabilities of movement of the oil price (both upside and downside) are taken into consideration and a list of possible prices is evaluated keeping a certain normalized price as mean ($45 per barrel in our example).
Oil Price distribution:
Now, estimating the value using the same approach used in Step 1 (estimating operating profit via regression analysis and subsequently calculating the per share value) at each estimated oil price and thereby taking an average of the resultant value, gives $62. The CMP (as of December 2009) of $64.83 suggests that the company is overvalued.
Cumulating the above two points, the decision-making process would be as follows:
If I believe that the company is more dependent on the company level factors (micro), then a value of $69.43 (step 1) makes it undervalued and hence I would buy it.
However, if I believe that the company is a mature one and hence depends only on the crude oil price (macro story), I would avoid buying the story as it is overvalued as per the value of $62 derived in Step2.
There are two reasons for separating your corporate stories into macro and micro parts:
- It will be clear to you, how much of your story comes from each component and will allow you to track your performance on each part. Thus, if you buy Exxon and the stock price drops, you can at least assess whether it was because you got the oil price portion of your story wrong or because your story about Exxon as a company was flawed.
- Your breakdown of the narrative into macro and micro parts is just as critical for someone hoping to act on your story, first, to aid that person in understanding your story and the valuation that emerges from it, and second, to help your listener judge how much faith he or she should have in your story. After all, if you have a woeful track record in forecasting oil prices, and the bulk of your story on Exxon is built on your oil price forecasts, I should be skeptical about your final valuation.