Counting the Cost of Capital and Marking Equity to Market

Your alpha opportunity is not just where the map differs from the territory. It’s where the map differs from the territory and where you understand how everyone else is misusing that map.

Continuing from the last memo, let’s move on to the balance sheet.

Counting the Whole Balance Sheet

Equity and debt from investors are not the only sources of financing.

Warren Buffett introduced many investors to the concept of insurance float – cash collected in advance from customers that is akin to a 0% loan. You might think of insurers as estimating the acquisition cost and default rate of these 0% quasi-loans.

There’s no reason you can’t extend this thinking to the balance sheet relationships with suppliers, employees, and the government as well.

Fig 1. Categorizing the Balance Sheet by Relationships

Source: Lembas Capital

If you think of these float sources as 0% loans, you should use a debt investor’s mindset to analyze them. These quasi-loans can be useful or dangerous depending on their credit, maturity, and liquidity profiles. For example, supplier financing through accounts payable has been a cheap capital source for Costco but also a source of pain for some factor finance firms.

Inventory and fixed assets are closer to real call options than quasi-loans. The company isn’t expecting its suppliers to pay the cash back if the inventory doesn’t sell; rather, the company buys the inventory with the expectation that this real option will end up in the money (i.e. a future customer will buy the goods). It’s a fun intellectual exercise to model writeoffs, depreciation, and amortization as decay on those real options, but so far I haven’t found it to be a significant source of alpha.

Rethinking the cost of capital may be more useful.

WACC Should Include All Liabilities

Cost of capital is a tenuous concept.

Charlie Munger amusingly calls it a perfectly amazing mental malfunction. Different people have different capital sources and opportunity costs. Why do we assume that every investor should use the same discount rate? Moreover, a company’s cost of capital is path-dependent at both the company level and the macro level. Why do we project one static discount rate instead of simulating many potential paths for cost of capital?

But, if we’re going to use this formula, we should count all of the capital sources. Here is the current definition of the weighted average cost of capital (WACC).

Fig 2. The Weighted Average Cost of Capital (From Investors)

Source: Magnimetrics

WACC should include all types of financing, including the non-investor sources (highlighted in Fig 3 in blue).
 
Fig 3. Cost of Capital Should Include All Liabilities

Source: Lembas Capital

Two companies could have the same traditional WACC (only debt and equity), but one could actually have a cheaper true cost of capital (including those 0% quasi-loans).

Non-investor capital sources have interesting nuances of their own.

Employee and government financing defer money owed, so they aren’t true capital inflows. They are, however, quite useful for large corporations with steady cashflow streams. Berkshire Hathaway’s ballooning deferred tax liability is a prime example here.

Customer and supplier financing are excellent potential sources of new capital as well. Recent examples of customer financing include KickstarterTesla’s $14b Model 3 pre-sale, and SaaS products switching from monthly to annual billing. Those longer pre-sold contracts can also reduce churn. Examples of supplier financing include Walmart extending their payment terms from net 20 to net 90 and, depending on how you look at it, small merchants guaranteeing inventory availability to Groupon.

Cheaper capital is not necessarily better capital to take. A more expensive capital source could provide benefits like branding, advice, and the opportunity to build other relationships. The potential for an ugly divorce with a cheap capital provider is also often overlooked. Whether that press hit, technical guidance, or new set of relationships are worth it really depends on each individual company and capital provider.

WACC can be an alpha opportunity when a company has an underappreciated capital source and, even more importantly, when that company’s cost of capital is about to change meaningfully.

Long investors can look for companies on the path to reduced cost of capital with underappreciated capital sources.

Shorts will, of course, seek the opposite – companies with unstable capital sources and on a path where the cost of capital will rise.

Entrepreneurs can intelligently use non-investor financing and recognize which signals can unlock these less dilutive capital sources.

The Market Value of Equity

When Luca Pacioli codified double-entry accounting in 1494, publicly traded stocks did not exist.

That’s probably why early accounting standards weren’t built to update equity values based on fair market value. Why pay attention to quotes in the stock market when there was no stock market to pay attention to?

To this day, GAAP accounting only tracks equity book value at historical cost – contributed capital plus retained earnings after taxes and dividends. If the stock market prices that equity higher or lower than book value, this new valuation is not incorporated into the company’s accounting.

The problem is that companies continue to transact in their own equity after going public. In fact, making it easier to transact in their own equity is the whole point of going public! A public company should have less difficulty selling equity to outside investors, granting equity compensation to employees, and buying back equity from the market. How can investors track these transactions if they aren’t fully reported?

The way to fix this is to add a GAAP line item for the market value of equity.

Fig 4. Adding a Line Item for Equity Market Value

Source: M.A. Gumport

As an aside, please don’t run away with the notion that I’m unaware of the debates over historical cost vs. fair market value accounting or that measuring fair market value could distort our return on invested capital metrics. I, too, laud the importance of rigorous cost accounting to anyone who will listen (much to the chagrin of my friends).

This new line item could be entirely separate from historical cost measures. As suggested in Fig. 4, we would maintain the balance sheet identity by adding “Equity Value Added” to assets and “Additional Market Equity” to equity. We could also separate mark-to-market moves from operating income in order to avoid jitters in the income statement. The latter point would answer Buffett’s related criticism of ASC 321, which pulls unrealized stock gains and losses into net income from operations.

Investors already indirectly track equity value added with metrics like the Q ratio and enterprise value. Directly tracking the fair market value of equity would make clear which companies are savvy dealers in their own equity and which ones are masking their underperformance with dilution.

Counting Shared-Based Comp the Right Way

Since I’ve already waded into what counts as a scandalous topic in the accounting world, I may as well carry on.

A line item for equity market value would also let us properly measure share-based compensation (SBC). The problem today is that we don’t mark SBC to market (highlighted in blue in Fig 5).

Fig 5. How Share-Based Compensation is Currently Practiced

Source: Lembas Capital

In practice, the appraiser’s initial valuation (#1) underestimates the actual equity dilution from an employee’s SBC. This undervaluation does not merely reflect the probability that the employee’s options could expire worthless; the low valuation also gives the employee a favorable tax treatment. So, we just need to true up the wage expense in the quarter that the employee options are exercised at fair market value (#2).

It’s a lot like the famous lemons problem in the used car market. The best employees are worth far more than the equity dilution from their compensation. Right now, it’s difficult for investors to see who is worth it and who is not. A cleaner measurement would make it easier for companies to generously compensate talent in equity and create a virtuous cycle of team building and product building. It would also shine a light on serial diluters who are taking advantage of absentee public shareholders.

The lack of clarity around marking equity to market and SBC creates the potential for significant alpha. It’s already difficult to screen for capital allocation – return on shares issued, return on shares repurchased, and acquisition deal structures. But the most important capital allocation metric is even more opaque – return on employees hired. Identifying the most talented teams is particularly essential in a world of short product cycles and ubiquitous online distribution.

For long investors, the alpha opportunity is to find entrepreneurs who are world-class capital allocators and underappreciated for it. Think of the greats. Henry Singleton issuing highly valued Teledyne shares for acquisitions and then executing massive share buybacks on the cheap in the 1970s and 1980s. John Malone paying 6x EBITDA (post cost synergies) in cash and debt to consolidate small cable operators into TCI. More recently, Mark Leonard adding niche vertical software products to the Constellation Software portfolio. Finding just one of these capital allocators early on would have made an investor’s career. In a decade, we may look back at today’s most charismatic team builders in the same fashion.

Shorts can look for companies masking low margin revenue models with unsustainable equity issuance. However, since this is a slow burning fuse, it probably won’t be a short-term source of alpha. Keynes’s quip that the market can remain irrational longer than you can remain solvent comes to mind.

For entrepreneurs, the opportunity is to create the signal that you are a Great Capital Allocator. If you can get investors to analogize you to one of the Outsider CEOs or to compare your corp dev team’s latest deal to one of the all-time great acquisitions, then you will find it considerably easier to raise investor capital.

Businesses Run on Relationships

That concludes our brief tour of alpha-generating opportunities arising from GAAP metrics as they are interpreted today.

Here’s a summary.

Fig 6. Alpha-Generating Accounting Opportunities

Source: Lembas Capital

How long these opportunities last will depend on how GAAP and fundamental investment strategies evolve over time.

Accounting was invented on pen and paper. Computers have the potential to radically alter the underlying landscape upon which investment analysis is built. (No, I’m not talking about putting accounting on the blockchain.)

Contracts are the connective tissue in modern economics in the words of Oliver Hart, the 2016 Nobel Laureate in economics. Hart’s work focuses on incomplete contracts because it is impossible for any contract to specify the optimal allocation of control rights in a transaction. And although no contract can be perfectly complete, every contract does contain a wealth of information about its embedded relationships. With the right reporting framework, we could graph networks of contracts between parties.

Put in plain English, businesses run on relationships. We want an easy way to see those relationships all at once. GAAP focuses on only one company at time, which makes it difficult to map those relationships and track how they are changing.

I think the future of accounting lies in agent-based modeling. We could treat companies as different agents to simulate how they are interacting now and how they might interact in the future. You’d be able to see each company’s network of relationships with its customers, employees, suppliers, investors, competitors, the government, and the public at large. Some of these relationships are barely mentioned in GAAP today.

Dozens of due diligence questions would suddenly be easier to answer with agent-based accounting.

Does a company have long-term or short-term customer relationships? Have the company’s suppliers started to provide interest-free financing? Are its investors going to be suddenly forced to sell out? And the scary one – is there some contagious risk that could threaten the company’s network of key relationships?

The capital markets would be much, much more efficient if this framework could be properly abstracted into software. But for now, that’s just a fun conversation to have after work.

I’m more interested in the alpha that we can generate today. And I think that GAAP and the way that investors react to GAAP reports will create significant opportunities for a long time to come.

I’m sure there are alpha-generating opportunities that I’ve overlooked. Pointers would be highly appreciated if you think you’ve found one and would like to discuss it – even if it’s just the kernel of an idea, I’d be happy to develop it together.

Separately, these memos focus on US GAAP. If you’d like to collaborate on an IFRS version, please feel free to send me a message.

You can reach me at research@lembascapital.com.

Thanks in particular to Ben Reinhardt, Kevin Shin, Nadav Manham, and Slater Stich for their help with this set of memos. I’d credit a dozen or so researchers for creating the building blocks for these ideas, especially Mike Gumport on the market value of equity and Thomas King on fair market value.