Session 6: Company Exposure to Country Risk Implied Equity Risk Premiums

B whole folks last time I'm going to ask this question and it's more to get you going than anything else okay so how many of you have not picked a company yet why are you pointing at her right so uh if you haven't picked a company please do and here's the reason Next Monday we have no class I'm sure you have big plans for President's Day but this is a freebie holiday right no obligations nothing to do you don't have to call your mother it's not Mother's Day you don't have to meet with family it's

not Thanksgiving day I'm not even sure what I'm supposed to do on President's Day but here's what I'd like you to do pick a company get started right so we won't have a CL class to next Wednesday and I will Operate in the safe assumption that by the time you come back next Wednesday you will have a company today we're going to continue our talk of equity risk premium right because that's the thing you're going to compute for your company Equity risk premum for your company and I laid the agenda for estimating Equity risk premium

starting with the traditional way the status quo way which is to Look Backwards historical risk premiums Assume that things will revert back to the way they used to be and I explain why I feel uncomfortable with it if you're comfortable with it by all means use historical Prem I I don't think it's a safe place to be but then I built on top of that right estimating Equity risk Prem for other countries today I want to go back to that first step is there a better way to estimate Equity risk premiums that's more Dynamic more

forward-looking than That approach we talked about last session so I'm going to start by laying out what I'm going to try to do and then I'm going to show you what it looks like right now when I try to do this and why I think this is a much richer much better way to think about implied think about Equity risk RS let's suppose you go out and buy the S&P 500 today inflation is throwing off things a little bit but it's at about 6,000 right you pay 6,000 you get the S&P 500 what have you

bought you bought the 500 larg market cap stocks in the US why are you doing it because you want to make money but let's get more explicit when you buy those 500 companies presumably you're going to get cash flows from the Holdings you have in those companies right so these are stocks the traditional way in which those cash flows came to you were what was the traditional way dividends but over the last 30 years companies in the US have increasingly shifted away from dividends to BuyBacks my corporate finance class we talk a lot about why

that shift happened but it's it this isn't some passing phase it is permanent and it's only going to get stronger across the world I think of BuyBacks is flexible divage y this is the the start of the class test are always the so when you look at each session there's a start of the Class test so the start of the class test is always separated from the packet so the packet is the same packet valuation packet one so every class will start with a test which won't be in any packet because it's just four pages

or three pages but if you go to the webcast page for the class it'll always be at the top right so you can download the page so this is really not meant to stick very long because it's really to get to prepared for what's coming in the Valuation package so you bought stocks you get dividends the the only thing about dividends and BuyBacks is I can't tell you what they will be in the future but I can tell you what they were in the last 12 months it's public information go to the statement of cash

flows you add up the dividends of every company BuyBacks so I have know what you paid for stocks I know what the cash flows were last year but you don't live in Last year's cash flows you want expected cash flows of the future what will cause the cash flows to change if earnings go up or your payout ratio changes the amount you return changes your cash flows can be different so let's say I can navigate that mind field come up with expected earnings in future years and remember this is the S&P 500 the most tracked

and followed index on the face of the Earth I've got the index level I now Have expected cash flows for how long will I get these cash flows these are stocks can go on and on and on forever I don't have the patience to go on forever but there's also a math problem these are the 500 largest market cap companies they can't keep growing earnings at a rate faster than the economy because the model will start to bre the economy will start to blow up so at the end of year five assumed that the cash

flows would start to grow at the Same rate as the economy for the rest of forever so you see what the structure is right if the index level you got expected cash flows the next 5 years and after your fiveyear cash flows grow forever to concentrate Michael the same way the S&P would or do you take the individual the S&P is a market cap weighted index so whatever you do has to follow that same rule because your initial investment So when you buy the S&P 500 right now what are the seven stocks that are going

to take up about 25% of your it's going to be the Max 7even and that's going to be the same thing your earnings your cash flows so that number actually if you you don't have to compute by yourself because the S&P 500 actually S&P does it for you because they do the same tracking on earnings and cash flows but if you download it from for yourself and you just add up the dollar values you're in Effect getting a weighted value right so it'll take care of itself but it has to be a weighted cash flow

last step I asked what discount rate makes the present value of my cash flows equal to the level of the index this is the question I'm asking right you're paid for stocks you didn't tell me what you wanted to make but given what you paid in your cash flows this is the return you can expect to make I'm almost there that's my expected return on stocks you Subtract out the T bond rate from that you got an implied equity risk premium why implied because I got it from the index will it change over time forget

about over time is it different now than it was at the start of today what's the one number in the equation that changes every moment of every day the price of the index and the T bond rate those are moving targets the earnings in the cash flows are more sticky but the index level changes your Equity risk Prem changes and in the right direction you know what I mean by the right direction this morning we woke up to some bad inflation news so what did the market do Drop My Equity risk premium get gets readjusted

so I'm going to show you the numbers so I'm going to start with pure intuitive questions I'm taking the index level the cash flows Computing and implied Equity risk what if I told you That stocks are up 20% the index level has gone up 20% what should happen to my implied Equity risk I'll give you the choices go up go down remain the same or you need more information to ask the question answer the question what do you think of this okay so first if if I hold everything else constant let's take the easy case

and it goes up what will happen to my Equity risk it goes down because when bond prices go up interest Rates go down same phenomenon if my stock price is up 20% earnings are also up 20% Then what happens risk is going to be roughly where it was if my stock price up 20% but earnings are up 40% my risk premium could actually go up because so you see it depend on what ha when it's not what stocks do that drives the AC it's what stocks do relative to earnings it's a dynamic number where everything

changes earnings and cash Flows might not change every moment of every day but they do change over time and you're trying to compute that steady state let's say you have a crisis say what crisis it's been one rolling around every year right it's only a question of time what happens in a crisis stock prices collapse essentially in short periods so when stock prices collapse what should happen to the aqu risk premi go up and that's exactly what you Should expect in the crisis right we now have a dynamic number that reflects what you feel in

your gut so today going to compute an implied Equity risk frams I'm going to show you what it's looked like over time I'm going to show you what it h what happens to it during a crisis but I now have a mechanism for computing the price of risk in the equity Market on an ongoing basis right you can actually set up if you if you want to do this and and it Rings your bell you want you're good with python or you can actually set it up so the implied Equity risk premium so you know

the Ticker on the top The Wall Street Journal ticker you replace it with your implied Equity risk premium ticker because it will reflect whatever is happening in the market and gets recomputed every moment of every day so let's go back to where I left you on in the packet now we are in the packet so from this point on for the Rest of the class will always be on the packet so that's I'm glad that question got asked because you're going to notice start of every class there'll be this packet that comes out of nowhere

so where did that come from three or four page test that's always going to be on the webcast page for this class not in bright space because I told you after the first session I'm not going back to that place till the very end of the class it'll be on the web page so you Can you can download so I left you with this way of thinking about Equity risk premiums by country right so remind me again so if I wanted an equity risk premium of a of a country where do I start what's the

process I went through first of all we can look at the rating before I do that though I need to get something nailed down I get a risk premium for the US right so we start with that and then you look at the Rating okay let's keep going so you got the rating then what you have the you can do like risk of the risk rate of the US no no before we do that with the rating I have to convert into something before I can use it oh you convert the rating to like default

spread basically and then you scale that default spread up for the additional risk of equities and then you add it to the US right and you do the with every country and if you don't have A rating then you wave your hands and you try to come up with a country risk score and try to come up with the risk prum now part of you as we went through this process probably said thank God I am going to go work in New York or London I don't have to deal with this crap now guess what

it's going to track you down so today's session I want to talk about you know so the different ways of thinking about Equity risk for how a company's exposure to equity risk Comes about again let's talk about the status quo and I don't like status quo right now is you tell me where you're Incorporated I give you the equity risk premium of the country you're Incorporated in so you're a Turkish company you're dead in the water right I don't care what you do I'm going to give you the equity risk PR for turkey which is

large and you got to live with it if you're an Indian company get the Indian Equity risk PR and if you're a US company you Coast right us equ spr I've never understood the logic of doing this if you're a German company you get 100% of your revenues from Afghanistan are you really a German company if you're a South African company and your M and your go comes out of Minds in South Africa and you list in London have you become a safer company in what universe is this even possible so here's the first fork

in the Road we come to do we look at the country of incorporation or do you look at where a company does business now I follow where the company does business side because that's where risk comes from where do you operate and of course there's Nuance here right how do you measure how you know where a company does business you could take the lazy way out and often the only way of available given information and look at where the revenues come from right That's a one metric that companies do break down by country or by

region and you can say okay I'm going to take a weighted average way you operate and for a big chunk of companies that's going to be fun but can you think of companies were looking at revenues could get into trouble yeah like mines country but if you're a natural resource company already saying who cares what the revenues are right my mines are all in South Africa I could be selling the gold in in Australia and the us but I have to get the gold out of the ground first so with natural resource companies it's not

revenues it's production could both matter some companies you can say well some of this is coming from where my factories are and some of it and we'll talk about ways in which you can decide how to weight them but you can already see that one approach is not going to work for every Company there's some companies where revenues are all you care about some where you look at only production some we look at both and then you're trying to bring it into your Equity risk so let's let's take the revenue case right I've taken two

examples here now first is embri and the second is both Brazilian companies with very different kinds of exposures the first is a 2004 calculation for it's probably not that different now in terms of Breakdown and Brier is a Brazilian Aerospace company and a very good one in fact if you've taken any shortle jets in the US you're probably either F flying a bombardier or an umbr so these passenger aircraft with 25 30 35 people on in 2004 embri got 97% of its revenues in the US and Western Europe develop markets with mature Market premiums 3%

in reserve if I base it purely on revenues the equity risk PR is going to look very Much like a US company with all of its revenues in the US the one catch though and this should worry you is where are 's factories all based they're in Brazil so Brazil go to hell in a hand basket the aircraft are not coming out so you could argue that I'm probably understating the risk of embri by just focusing on revenu but for the moment you know why I focus just on revenues because that's the only information I

was actually able to find Which is public information and Bri didn't break down where the production was you have you could figure it out but it wasn't the second company is company called MF MF started as a Brazilian Beer Company became a Latin American Beer Company and now is part of the imbe Empire mbeb is the largest Brewery in the world this was a 2011 valuation of mbeb where I looked at their revenues and they' broken it down by country and you can see it's now a Latin American Company it's a Brazilian company that gets

revenues all over Marcado Libra which is this you know online Latin American retail you look at the breakdown it's a Latin American company so I take a weighted average these are numbers that are public information you don't go you don't have re you don't need research in the public documents the only problem is countries companies are kind of casual about how they break the world down us companies Are among the worst you know how they break revenues down 72% in the US 28% in the rest of the world come on guys that's a big space

out there could we start to get a little more specific or sometimes with European companies there there's a different way in which they frustrated they say you know they they'll break the revenues down 31% in Germany 69% from EMA you know what EMA stands for Europe Middle East and Africa okay guys you bundle three parts of the world together with very different risk profiles you're saying what do I do if that happens you take what you can get right you can estimate an equity risk PR for em and guess what it's going to be more

you know more Europe than the Middle East and Africa simply because so you look at GDP you make your best judgments but that's the starting point you can use revenues Coca-Cola has Regional Breakdowns yeah yeah we're still saying with revenues we'll talk about it because each of these cases I'm ignoring the production right with EMB with with embri now with Coca-Cola I'm going to argue that I'm worried less about Coca-Cola and Mev then with embri I'll talk about why but production is always this this wild card we're not even talking about partly because the information

is not there but you're Saying what if that breaks down or Supply chains now right remember in 2020 your supply chain was only as strong as its weakest link and if that weakest link was going through a part of the world where everything had broken down you never got the supply chain going with uh Coca-Cola they break the revenues down by region and I don't blame them if they broke it down by country This would run to 72 lines and 72 countries one of the reasons if you Go back and look at my Equity risk

premium map for the world I compute those Regional weighted averages is because of companies like Coca-Cola where things are broken down by region so take what you can get with revenues and it's probably the one metric you can get in Computing equity RIS PR but it is going to be an issue and I think Adil brought up the point where is my production coming from you're not factoring it in and the other is I'm Taking this Equity risk multiplying by a beta you're saying so what well beta was designed to cap measure risk against all

kinds of macroeconomic risk factors interest rates inflation I'm asking it to carry one more burden right and there's an argument to be made that country risk is very different from all of those other risks and we'll talk about why so I want to address those two questions what if production is where your risk Comes from how do you bring it in the process and is there something other than b you can use to scale up country risk so let's start with the companies and I think it this already brought a natural resource company a mining

company an oil company who cares where you sell your stuff you sell it into a global market it's where you get the stuff that matters this is Royal Dutch in 2015 oil and gas company And they break down in their annual report again this wasn't research on my part this is actually in their their filing they break down where they get their oil and gas and you know what the equity risk premium for Royal Dutch was higher than the equity risk premium are using for many Emerging Market companies and the reason is simple oil is

in the riskiest parts of the world and by the time you factor in where you get the oil the equity RIS SC goes up so you can Have two oil companies one is entirely Shale oil based in the US and the other gets half its oil from Venezuela and the other half from Russia they're both oil companies both based in the US but you're going to get very different Equity risk P so those are the two extremes right you can have all revenues all production let me go back to why I was less concerned about

production with the Coca-Cola than I was with an Embro you know the gross margins were you first you know what a gross margin measures right it measures the cost of making the next units up what is the gross margin for Coca-Cola look like what do you think that that soda can you bought for I don't know $150 $2 out there which Coca-Cola might have sold for 80 cents what do you think it cost them to make that almost all of the cost must be the Can right what's in it is this sugar water with a

bunch of flavoring thrown in and carbonated the gross margins for for brand name beverage companies is 85 or 90% what does that mean your production costs are a tiny fraction of your revenues now do you see why I'm not that that worried about the production side for Coca-Cola it's fixable right conversely though when you look at Embri even if they're insanely efficient they're not making 80 I I think that gross margin is closer to 30% one very simple indicator of how much you should be worried about your your production side is look at gross margins

brand name companies you're less worried about production than you are about revenues and you can then use those as a basis for weights you can bring in both sides of the equation how much where do I get my revenues where do I get my Production and the weights will be based on now what do my gross margins look like and how much should I care this is not a black and white scenario we said use revenues you can use both and you have to make your best judgment on which one will work for your company

any questions on waiting to get an equity risk premium yes the production um scenario that we saw could this also be a factor that for An irland gas company you cannot really move your production that's actually that's a good point to make is the more mobile your production is the less you worry about where you produce things right infosis might get all of its software written in a building in Bangalore right let's say India Goes to Hell in the hand basket they can take all of those people put them on three jumbo Jets if they're

still around take them to some island in The middle of the Indian Ocean give them Wi-Fi and your production is back online right tart Motors is concerned can't exactly move its factories overnight and of course if you're an old company you're kind of stuck so Mobility is going and that's part of why I'm going to bring in the Lambda Factor because Lambda you can already see there are layers that you have to worry about so let me talk a little bit about lambdas So it's a measure I concocted notice the word I use I didn't

derive it because it suggest deep thought I concocted on a long flight to Brazil about 20 years ago there an overnight flight of red eye I was taking it out of New York I was supposed to teach the next two days in Sao and I had a person on the the next seat who was oozing into my seat making it very difficult for me to fall asleep I had nothing to do so I start reviewing The slides I was going to use for the next day at that time I was doing what the conventional practice

was treat all Brazilian companies as equally exposed to Brazilian country risk and the two companies I was looking at were I think Emer and EMB brle Embraer of course is the Aerospace company EMB brle at that time was the Monopoly phone company for Brazil got 100% of its revenues in Brazil I was treating them both as Brazilian companies giving them that big Country risk premium and a big cost of equity and about a third of the way into the flight I said this doesn't make sense I was probably woozy at that stage I should be

treating them differently I should be treating and I said I need to come up with something that gives embro a lower cost of equity than embro so that's when I said be nice to have something that looks like a beta that I can multiply by the country risk Bre looks like a beta what and a number that's scaled around one so when that number is below one you're less exposed to Country risk above one you're more exposed to Country risk and I decide to title that measure Lambda why because attaching a Greek alphabet makes it

much more difficult people to critique you sounds like you did a lot of deep thought so I called it Lambda and I landed in Brazil I was exhausted but I Tau all day in a midday through the day I come up with this and I throw this idea out and some person in the front row who's I think trying to make trouble says that's nice but how do you plan to measure Lambda and he said I don't know I have a long flight back and I'll think about it then and on the long flight back

I came up with multiple things I could look at to measure Lambda what are the things that will affect exposure to Country risk first you could hedge or ensure some country risk right so if a Company is exposed to Country risk and it's hedged it or insured it I should give it a lower Lambda than a company that does it of course requires me accessing country risk so when I was thinking about it I said let's assume I access to whatever information I wanted what would I ask for I also wonder what happens when a

company is classified as being in the National interest in every country there are Companies in the minute that happens your country is just doubled why because the government just feels then the incentive to step in and say you can't do that to that company so National interest companies start to factor into the Lambda so I made a list of things that I would like to know and then I looked through an annual report to see how many of those things I could get data on and the answer was Somebody's giv you none of that information

so I said what can I do with public information to come up with the Lambda so I started simplistic what's the one metric I said companies routinely break down revenues right so I'm going to give you a revenue based estimate of Landa so I'm going to take two Indian companies tataa Motors and TARTA Consulting Services both part of the same family group in India both Indian companies very different profiles In terms of where they get their revenues so while back TARTA Motors at that time was getting about 92% of its revenues in IND that number

is now down to 70% you know why cuz Jaguar Land Rover has gone much faster than domestic T Motors and it's become a larger slice 91% T Consulting servic has got about 8% of its revenues in India already you can see the Divergence but I want to convert this into a number That looks like a Lambda right so I took the average Indian company which gets about 80% of its revenues in India and I divided each of the numbers 91 and 8 by by the 80 it's extraordinar simplistic way of getting Lambda but if I

do that the Lambda that I get for TARTA Motors is 1.14 what does that tell me tart Motors is more exposed to Country risk than the typical Indian company whereas TCS is much less exposed confession I'm basing it Entirely on revenues all the weaknesses that revenues have so I said maybe there's a more composite thing I can look at which captures the rest of the story as well do remember how you estimate bet is the traditional way what what do we do run a regression of returns in the stock against returns in the market index

right what is the beta measure it measures how sensitive your stock is to movements in the equity index what am I Trying to capture here with Lambda I'm trying to capture how sensitive a company is to Country risk movements right I'll tell you what I tried was a mess it took me a while I will never do it again is I took the Returns on embro and emle this is after I got back couldn't do it on the plane because my Wi-Fi is obviously non-existent then landed I pulled up the returns I think monthly returns

both the embro and embro then I Also pulled up the monthly Returns on a c bond you know what a c bond is it's a Brazilian dollar denominated Bond why are you looking at this remember when you with country risk when a country gets riskier what what should happen to the price of so Brazil is viewed as risk here what should happen to the the price of the the c bond it'll go down the return of the T so basically the return in the c bond becomes a proxy for Country risk because what goes into

C bond since dollar based rate is the t-bond rate which is nothing to do with Brazil plus a country risk premium that the market is assessing a Rand that regression the slope of the line what does that tell me it tells me how sensitive embro and embal stock prices are to changes in country risk take this with a grain of salt because there's a big standard eror on each of these coefficients if you look at the Regression I got for Embraer every 1% return on the c bond up or down Embraer is up only 27%

makes sense right less exposed to Country risk the market reflects that in contrast embal which has everything in Brazil and it's in the National interest right it's it's a monopoly company the Lambda I get is two I have to confess to you lambdas are incredibly painful to compute I almost never use them unless I have a company With a singular country risk exposure that I'm really conserv Nigerian company and I'm saying Nigerian country risk is a big country risk then it might be worth doing it otherwise go the weighted Equity risk premium approach don't do

this with Coca-Cola you really want to estimate 72 lambas maybe you do I don't it's a pain ful process but essentially it allows you to come so I'm going to bring this all together because I've thrown all these different ways of Estimating Equity RIS which one should I use I'm going to kind of try to converge on the big choice I made I took embr and I computed five different costs of equity in each of them I did didn't all in US dollars because in 2004 there were no 10year Brazil injury I denominate Bond so

desperation drives me to the risk free rate so that's why you see the 4% leave the base as is for the moment we'll come back and talk about how do you get a beta for a Brazilian Aerospace Company and the differences came primarily from two things one is whether I viewed embri as a Brazilian company and attack the entire country risk Prem for Brazil which was 7.89% then to the cost of equity which case I get 16 177% of my cost of equity or whether I treat embri as a company that gets all a lot

of its Revenue so whether I use a Lambda whether I use that weighted average Equity risk premium that's going to give me a much lower number 9% 10% you see what the big Choice here was you if you decide to treat bra embro as a Brazilian company you made the Big Choice you're going to come up with a much higher cost of equity than you so when you ask me should I use Lambda should I use weighted averages you're already playing on my side of saying your number is not going to be that different I'm

going to say do whatever you want to do and move on because you already made the Big Choice the Big Choice was not giving and Brier a Brazilian Equity risk premium because it's a Brazilian company yeah very close right because if your beta is pretty close if you look at the weights 97% come so it it's as math works out right that's why I said those within those approaches once you made that choice the numbers are not that different so let's step back right I've made the argument and you might disagree with that that a

company's risk exposure Should come from where it does business but there is this view in the world that a company's risk exposure comes from the country it's in the market make can pick whatever it wants which one do you think the market goes with most of the time it goes with the where whichever country you're in an Indian company you're an Indian company and you know when it's worse is when you have a crisis which Indian St get Sold all Indian stocks I mean right now India is going through a little bit of a crisis

I've been blamed for it over the weekend I don't know how I entered the conversation I take no responsibility for it it's down like 15% and everything is being sold TCS clearly markets are not that discriminating right and and if you've agree with me that country comes from where you operate they are pushing down Down the prices of these companies too much which companies the tcs's the enforces of the World by treating them as Indian companies let's let's carry that forward if you believe that markets systematically make this mistake of treating all Indian companies as

you know giving them the same and pushing down the prices of even companies that should have what will that mean as an investor For you which companies are going to look undervalue to and which ones are going to look over value so you look at an emerging market like India after a correction like the correction we've had which ones are you going to buy Julian what do you think you'd buy would you buy the companies which have less exposure to India or more exposure to India as exposure and then you get down your knees and

you have to hope and pray that what Happens that markets eventually come around your point of view what's the guarantee none I mean markets can do whatever they want but I have adopt over the last I have a list of every and you can try this out come up with your own list go to each market pick a company or two just like embra Right company that is in that market but gets a bulk of its revenues outside Vietnam it could be vinam milk in Turkey it could be Turkish Share right and then what you

do is you sit and watch what are you waiting for a crisis you saying what what if there's no crisis trust me there will be one it's not a question of whether it's a question of when and then make it automated right because you decide then you're going to make the bu decision you will hold back right essentially put in a buy order I actually bought andri for the first time after Lula won election for the very first time in Brazil and You're probably too young to remember when he first won election but when he

first won election people were convinced that as he was a communist he was going to nationalize everything the markets completely imploded and everything got sold off including am Brier right eventually the truth came out you know what causes the truth to come out not some Sage speaking or a blog post it's after the crisis embri continues to report earnings right it Still has its long-term contract so even though the rest of the market is melting down they able to report good earnings and after about the third earnings report investors wake up and say maybe it's

not that brizzle in a company its numbers look pretty good that's what you're hoping for as your correction so think about this because it is actually a interesting way of thinking about the divergences that are being created within Markets so now we're ready to talk about implied Equity risk premiums so I've set up the process right it's an internal rate of return Yes happen in Brazil but it's highly dollarized I can don't use the word dollarized right it's you so oil companies really your risk comes from where you get the oil right there's no dancing

around so Petras might sell all of its oil into an oil Market but if as long as the oil comes from Brazil and Its reserves are all in Brazil it's going to be completely exposed to Country risk it's very difficult to escape country risk so ramco where does it sell it's oil I mean everywhere right it's for about 30% of the oil in any given day could come from a ramco but now valued rco that was a valuation of the week the equity risk premium I used was just Saudi Arabia's Equity risk premium because everything

rides on where you get Your I thought you were going to ask me a different question because I talked about how Emerging Market companies with lot of develop Market exposure tend to get undervalued do you see the flip side of that in develop markets what kinds of companies are going to get overvalued us companies with a lot of overseas exposure right you think that's a US company then know Coco you wake up there's a Russia crisis and then we act surprised what's the Surprise you get 30% 25% 50% of your revenues from Emerging Markets it's

again the surprise is going to happen you're trying to build that in proactively into the required rate of return so let's talk about this yes go ahead Jen um principle of like oil companies their risk is tied to where they're actually getting their oil br is that true for companies that like Supply like most companies that Supply natural resources or some Any natural resource company you're kind of Trapped By Nature right like lb example these are very tied to no but now we've left the natural resource there's nothing that lbmh does that's natural right so

let's get that out of the way right everything is concocted so it's whether it's Cosmetics or lipstick or whatever else you sell or it's all made so there's a manufacturing facility what's the number you're going to look at to see how much You have to worry about the production cost at Lage I kind of talked about as a gross margin you know how much uh I know you know I can't tell but Gucci for instance you know how much the actual Gucci bag costs Gucci to make barely more than what the Canal Street guy spends

on making a Gucci right it's not like you have highend incredible materials it's marked up to $1,000 so if you're looking at Gucci I frankly couldn't care where You make you might actually end up buying the stuff on Canal Street and actually selling an actual Gucci and I wouldn't even notice right there I'm going to argue it's all about revenues right but if you are a company that's like temo which just marks up your margins at 3 5 7% I'm much more concerned about where does all that's a mistreating because you've can buy all kinds

of things on temo and you said where do these things get made kind of a Clue but I don't want to dig any deeper it's going to be more about where is the factories because that's what's going to drive it so again it's a common sense way of saying I mean the way I like to think about is if you're a manager at this company what keeps you up at night right and if you're Coca-Cola I guarantee you it's not your cost structure in your factories that are keeping you up it's your branding it's Your

advertising it's what people pay as a premium right if you're an old company the only thing you think about all day long and all night long is my all's all in kazakistan in Nigeria how the heck am I going to get it out of the ground so that's actually a good way of think about put yourself in the shoes of a manager in the company say what would drive you know what what what gives me nightmares and then bring it into the process Yes yeah Transportation yeah that's so you added another layer right you got

the oil out of the ground Nigeria you got to get it onto ships and the ships you got to get the oil to so there and the it's got to go through the canals which have now been stopped that's a so you can actually argue that there's a third dimension here which is the supply chain Dimension which after 2020 might be a factor you might actually have said That's where my risk lies but now we have the mechanism for doing this I would look at the countries the supply chain go through and bring it into

your Equity risk premium but we're now talking that's a healthy discussion of risk rather than say tell me way you're Incorporated okay that's your Equity risk premium so let's set up the implied Equity risk premium approach you already saw the basis right it's an internal Rate of return there's no Theory no model it's completely model agnostic you tell me what you pay I back out the internal rate of return which effectively means that when you get scared you push down prices I come up with a higher premium and then I come up with an implied

premium it's Dynamic it's constantly changing I set it up at least in the abstract that the page you saw already as part of the the test today but when you look at it there's no Numbers in there right so let me show you what the numbers look like on January 1st 2020 I was getting ready for my 2020 valuation class I think this this year is going to be easy right doing this for 34 30 plus years how difficult can it be and I comput and implied Equity risk in January 1st index was at 3231

expected cash flows I took the dividends and Buybacks in the most recent year Projecting the mark after year five I assume that the cash flows will grow at 1.92% a year that sounds oddly precise saying where the heck did you come up with the 1.92% it's my risk R it's you're going to see me use this trick all the time in valuation when you get to steady state the best estimate you can get for your nominal growth rate is your risk rate rate and I'll show you the tables that back it up you can ask

macroeconomist You can ask the t-bond and the T bond is always right have the cash flows I solve with it in Excel I use the solver or the gold seek function because it's a messy equation to solve I get an expected turn of 7.12% what does that tell me at the start of 2020 people were pricing stocks to earn 7.12% the T bond rate was 1.92% so before you said that looks low 7.12 You're opport your alternative is to invest in something risk fre at 1.92 that difference is 5.2% that's what I started 2020 February

I Rec I do the start of every month I recomputed the number very close to 5.2 there's February 14th I'm still in a state of complete denial this is virus but it's all in China and cruise ships why should I worry about it and then we woke up on February 14th to a new story From Italy remember that that the Italian government had found Co in Italy from people who never been on a cruise ship or to China and the nightmare began that's February 14th through March 20th 6 weeks if that five weeks take a

look at what the equity risk cre the so I actually that year I tortured Myself by Computing the implied Equity Rim at the start of every day had Nothing else to do I was stuck at home anyway might as well spend some of the time you know rather than learn to cook or something which you know bake which is a complete waste of time I said I'll complete the implied Equity risk cream every day and there it is right in a five week period the implied Equity risk premium went from about 4 and a half%

to 5% all the way to 8% don't ask me what happened you were There you knew what happened right I don't think people remember how terrifying it was was in terms of what was coming in hindsight we put it all the I knew everything was going to be okay I knew a vaccine would be developed by November I knew the econom really I kept a journal through that entire year to remind myself of what the things that were happening then and how scared I was because in hindsight it's amazing how you can Pap for this

Up what made this crisis different than previous the same thing happened in 2008 I kept racks from September 12th to December first of that year every day it actually is a way you can keep yourself Sav because in a crisis you know what else happens right you listen to people telling you the world is ending the next thing you know you've done all the wrong things this keeps me kind of grounded it's okay it's okay I can computer impli equ risk premium Still what in the 2008 crisis though you got hit 8% November 20th I

think of 2008 and that number did not come back to pre2 2008 numbers for about 6 years you know it's different about 2020 is there's a crisis by September it's almost like the market at it's over and in fact the market was at odds with experts right because experts said vaccine will not come for two or three years at least no vaccine has ever been developed this quickly and The economy is going to crash and birth and the market said no I don't think so you know in the last four years every time there's been

a contest between the market and experts who wins look at say Market was right last year during the election I listen I read Nate Silver's post and I read the what the New York Times con writing the New York Times and then I followed Kashi you guys follow Kashi it's this marketplace where they Actually allowed you to trade Trump and kamla Harris and it did a much better job all the way through of predicting what was going to happen so now the advantage of doing this if you did with with a historical premium I could

not do this right because all it is it stays the same I'm in the middle of the worst crisis it's like having a blood pressure gauge on you that always tells you you're okay 110 over 70 and Your blood pressure shooting through 240 or on the verge of having a heart attack and says no you're okay okay an implied premium gives you it might be noisy but it's giving you an updated number so at the start of 2025 we're now getting closer to today the market was at 5,881 billi I computed an implied premium again

so if you look at the expected return it's 8.91% that's better than the 7.12% you saw in 2020 right but what else has Changed the risk free rate is now 4.58% your opportunity has become more lucrative in terms of not investing in stocks that difference gives me an implied Equity risk of 4.33% February that number is down a little bit because stocks are up you a little bit to 4.27% here's the way this plays out my valuations all of the valuations I did in January 2020 and I probably valued About five companies My Equity risk

fream for the US and mature markets was 4.33% this this month I valued two companies Anka the Turkish company I revalued lvmh and this this month I am using 4.27% what will I be using in March I don't know but it will reflect what the market looks like it makes me live in the market I'm in not the market I wished I was in kind of forces you to ground yourself so any questions about the Mechanics and what what I'm trying to do here go ahead how are you calculating earnings the period before the earnings

year basically what happens is I get two I can get two years of forecasted earnings from analysts or at the best 3 years for the S&P 500 so I do the three years the actual earnings numbers right from the analyst because they give you the they make the predictions and then I know my growth rate is going to be 4.58% after year five all I do is I go and linear steps so basically if it was 7% or 8% for the first three years I go 8% 6 point something per so it's essentially bringing down

and to be quite honest if you finessed it it's not going to make much of a difference the bigger thing is what you assumed so that's the smoothing out effect I do to get down so I don't want to dramatically drop to 4.58% in your five right and it's in terms of how much it matters and What my final Equity risk premium is it's about third or fourth in the list it's not the big deal the big deal is that leading number the dividends and BuyBacks are already 4% of the index that's your starting point

so your index is going to be know Equity risk premium is going to reflect those cash flows yeah you know you said you live in the market that you're in but when we did our first uh assignment that you that I let you so basically you got to separate What you're doing so if I ask you to Value Coca-Cola you got to live in the market in because what am I asking you you know how you have conditional expectations I'm asking you for a conditional valuation given where the market is today is Coca-Cola cheap or

expensive so let's say answer the question then I say what do you think about the market today you know the reason I separate the two questions the answer to the second question drives my Asset allocation decision so if I think the market is overvalued what should I do invest Less in equities more in bonds but within that Less in equities I'm now going to come back and say I would investing only 20% equities which company should I buy that question is really a conditional expectations question so I want you to separate the two it's not

that I don't want you to have a view in fact that's going to be my next step you look at the 4.33% and you ask is that enough we're in bubble territory now right in terms not in terms of Market being there but in terms of people talking about bubbles we've been in bubble territory for the last 10 years we're surrounded by bubblers and the bases for the bub I don't have a problem with you me telling me the Market's in a bubble but what's a core Factor driving people to tell you We in a

bubble what what is is more bubble talk now than maybe 10 years ago why is there more bub talk price earnings is higher one is the price earnings ratio is high their favorite metric right p ratio is 23 what else which is another way of flipping it you flip the earnings with priced earnings you get an earnings Shield it's less than the t- bond rate Michael the curve invers that that the E curve is now back To being very mildly positive you squinted it looks like it's going up it used to be going down but

also we've come off two really good years for stocks let's face it when you have two three the longer you have good times the more you say okay maybe the party is going to stop so I understand people are anxious they're worried but this can't be the basis for saying the market is in a bubble right because then you'd have been out of stocks in 2016 2017 20 there Have been there are people who' have been out of stock since 2013 because they feel the markets in a bubble so we've got to do this with

a little more discipline I think the equity risk premium gives you a way of framing whether the market is in a bubble so let's take a look at the acis 4.33% right now right you think that's too low too high you think you're okay with 4.33% at you're looking at the chart right and I'll tell you what the chart says this is the implied Equity risk the S&P 500 going back to 1960 the average across the last 64 years is 4.25% so you should go to bed comfortable right but let me throw you you look

at post 2008 which I said divides the word up pre2 the implied equ has been closer to 5 and a qu. now you see why we can disagree about the market but those disagreements Really about should the fair Equity risk premium be 4.25% or 4.25% Market's very value if it's 5 something per what you telling means the market is over Val so the question becomes are we looking at a number that is so low unbelievable this graph actually kind of gives you a point in time where you looked at the number say no way even

though you were finding ways to invest In stocks Jesus so this is implied Equity risk PR going back in the US you can see the 1970s implied Equity risk pops through the road what caused you to do that inflation inflation is deadly for stocks and you see that play out in a little piece today right 3% what happens next 1978 you know what the Dow is at 75 Zer there were three numbers in the Dow where at 30 something something thousand 40,000 I remember Business Week headline in 1978 said stock are dead what does that

tell you whenever the financial news gets on tell you stocks are dead it's time to buy stocks like they're going out of style because between 1978 and 1999 you had one of the great bull markets of all time remember the equity risk Prem is going up stock Price are going down the equity risk Prem is going down stock in fact you put in the dot Boom by the end of 1999 the implied Equity risk premium in the US I remember my 2000 class I present the 2% aquadis premium t- rate was 6 and a half%

I was offering you 2% more and I said how many of you take a 2% premium to to a person every person in the class said I won't and then I said how many of you invested in stocks and They were all fully invested in stocks why the world has changed there will never be another recession again because of the internet I mean that's in fact there was a view that the world had shifted of course in hindsight it was wrong we bounce back to 42% 2% is definitely bubble territory 4.33% we're in that gray

area right you can say stocks are expensive because you're getting a low risk premium relative to the last 15 years But this isn't sell everything head for the hills kind of risk premium the reason I track the equity risk premium by month is I want to know when I'm in a bubble not after the fact but while it's happening and this gives me a device he saying how is this different from using a price earnings ratio what's first price earnings ratios will come back and address but what is the if I use the PE Ratio

is my only metric what am I missing what are the Things let's take the last decade P ratios are higher than they've ever been but what was also true about the last decade that explain those highp ratios T not just growth rates the t- bond rate was really low right so the fix for that was to take the earning Sur price rati and compare the t-bond rate which is what the financial times the Wall Street Journal did a few weeks ago and said stocks are in a bubble now you brought in the t-bond Rate you're

using the earnings to price ratio but you're using last year's earnings you're ignoring growth you're ignoring cash flows the fact that they can change it's a very very very blunt instrument to decide stocks are cheap or expensive and Equity risk just dressed up PE ratio right because I'm bringing in the ratio it's in there I'm bringing in growth I'm bringing in cash flows I'm bringing the t- bond rate because I want to be able to tell you that I have Control for those things before I give you this number so I will send you my

February 20125 implied premium spreadsheet it's a very simple spreadsheet you can update with today's S&P 500 today Ste bond rate run the gold seek you'll get the impl you have a of updating your equ screens you don't need me to publish this on my web page there people actually email me say you haven't published it's February it's March 3rd And know you haven't put your said the spreadsheet is there do it yourself I'm not feeling like doing it right now no I'm in Disneyland so do it yourself make it your spreadsheet modify it adapt it

adjust it because you can see what I'm doing is not rock ET science so with that implied premium there are a couple of interesting followup questions that I wanted answer here's the first one his implied premum 4.33% is on a 4.58% risk free rate the implied premum of 5.2% in 2020 was on a 1.92% risk free rate you see where I'm going what if the risk free rate goes to 10% or 12% of 15% my question is will the equity risk fre have to get larger because now you have earning on top of something so

to answer the question I looked at t- Bond rates starting in 1960 going through and put the equity risk PR on top I was Wanted to find out if when t- Bond rates are higher Equity this is a purely empirical question we can dance ourself around and the answer in the US is there's not much relationship between the level of rates and the risk premium except in the 1970s so how would I read that if inflation truly becomes 78 9% I would expect Equity risk premiums to go up but three to even three and a

half% we can live with that Right Equity risk premiums but if you ask me to estimate an equity risk premium for turkey if I start with a 21 a half% risk free rate I might say look you know I'll settle for a 6% premium if risk free rates at 3% but at 21 a half% that's got to be a much higher number because I'm building off a much bigger base there's a second question I wanted to answer Equity risk premium is the price of risk in the equity Market but there's another big Market out there

the bond market the corporate bond market is there a price of risk in the in the corporate bond market what's it called it's called a default spread right just like the equity risk changes all the time so when people get scared in one market are they getting scared in the other Market it's often the same people right how can you say I'm terrified of the equity Market I'm Feeling okay in the corporate bond market so I wanted to see what the price of risk in the bond market did and look at whether it moved with

the price of risk in the equity market so in this graph the red line is the implied Equity risk premium the black line is the spread on a baa rated Bond that's an investment grade Bond so it's a pretty safe Bond and you can see that default spread also varies across time most of the time the two move together but there Have been two periods in the last 30 years where the two have moved in different direction ctions and if you P if you'd been paying attention it might have saved you some trouble let's take

the first one there's the 1990s boom what's happening the equity risk keeps dropping and dropping and dropping it's down to 2% the default spread actually stays intact in 1999 you were actually earning a higher spread on a baaa rated Bond than buying equities as a Class so if you're an investor and you are actually looking at these two numbers and you making decisions from scratch and rationally where should your money all be invested it should be invested in bonds because why would you want to expose yourself to the risk of equities if you're making this

is an investment grade Bond of course people weren't listening will talk about why this was this comparison wasn't jumping out at people Then you move to n 2001 of course 911 happens and Alan Greenspan says I will not allow the US economy to go into a recession the hubris of Central Banking and he tried right the way he tried was he essentially pumped money into the bond market effectively pushing down TOA spreads there's a the green span effect but the equity risk premium stayed where it was so now you're in 2006 your default spreads on

bonds have Dropped to historically low levels you can earn a reasonable Equity risk premium still you can see the reverse of what you did in 1999 what happen and of course when you push default spreads too low think about the consequences what's happening as lenders you're charging too low an interest rate to cover what the defaults that will come reality doesn't wait for Theory to catch up in 2008 reality caught up which is default started coming and you hadn't Charged enough of a default spread I described 2008 most Market crises in the last century have

been caused by equity investors Behaving Badly 2008 was caused by Bond holders and Banks Behaving Badly collectively that's at the heart of almost everything that went wrong you saying what about the subprime crisis what's the subprime crisis somebody described that to me what was it jagti do you remember what the Subprime crisis was what's subprime first risky borrowers right can you build a business lending to risky borrowers yes as long as you do what charge a high interest rate come on money lenders have been around for 800 years lending to risky borrowers and they've been

a Prett it's been a pretty lucrative business to be in you know the problem with 2008 not that you were lending to risky borrowers but you were lending to risky borrowers and charging Them investment grade rates that never ends well and of course that correction led to 2008 saying that obvious in this graph why weren't people catching on because we end up with tunnel vision once you go into markets many of you have jobs lined up I hope but your job is going to be either an equity job or a fixed income job right and

if you end up with an equity job guess what you focus on Equity Equity you don't even you don't have lunch with the fixed income guys they're strange you hang out with your own tribe and the fixed income guys as the equity guys are very flighty and speculative I don't want to hang out with them it's me to the botom each market kind of is insulated from what's Happening the other Market one reason I started doing this was I wanted to see what these two markets are doing because there is Information in there one of

the few things that I think hedge funds especially macro hedge funds bring to the picture is they step back from The Fray they can look at different markets and say you know what this Market looks cheap this Market looks expensive and essentially try to take advantage of the mispricing so you got Equity markets price of risk is the equity risk Bond markets is a default spread any of you in real Estate you were in real estate doesn't matter you know wherever you were in real estate there's one number that drives how much you were you

in real estate re okay Tech person right Tech real estate we work right it could be real estate version but in real estate there's one number that determines how much you pay for a building yes cap rate it's called a cap rate what's a cap rate I don't know why real estate Wants to inv terms when you have terms already out there cap cap rate for a for lack of B is like a cost of equity that's basically what it is they call it a cap rate here's how cap rate works let's say of a

building with a million dollars in rental income and you want to decide how much to pay for it if your cap rate is 10% you'll pay Million divid by .100 which is $10 million if your cap rate is 8% you you pay 12.2 million if it Becomes 5% you pay 20 million so you can already see that as you lower the cap rate cap rates are driven by Risk by greed and fear just like the other one so when people get terrified in the real estate market what happens cap rates go up the price of

real estate drop so I went looking for cap rates over time to see how cap rates moved now I'm getting really messy I have three different markets here the Red Is My Equity risk premium the black is the bond default Spread and the green is my real estate risk premium and it looks a little strange right especially in the two decades towards the end of the last century it's actually negative why would you invest in an asset class with expected returns that are lower than what you can essentially make even on a risk-free investment why

would you do that plus you can say these people are crazy real Estate developers driving the prices they don't know that could be an answer but there's another one I when I did my MBA one of the big lessons that was conveyed to people is now real estate as an asset class is a good thing to invest in if your money is primarily in financial assets and what was the logic driving why you should invest in real estate because you will be protected if the final it doesn't move with financial Assets that real estate moves

on itself Zone that slightly or even negatively correlated with financial assets 1970s stocks horrific decade worst decade in history bonds even worse you know only two only two asset classes that held their value one was gold because does it with inflation the other was real estate so go by real estate and if something is negatively correlated that's like having a negative beta right So the asset class should in fact have a return lower than the risk free rate so they sold us all on investing in real estate but investing in real estate comes with a

problem right it's lumpy what does that mean you have to buy a house or an office building it costs tens of millions of dollars you an invest with 2 million to invest how the heck are you going to add real estate to your portfolio so what did Wall Street do in the 1980s starting with lurin y They securitized real estate it met Demand right now you could buy real estate as an individual investor either in the fixed income side of the equity Side by buying and came with a side effect that I don't think we

think about when we think about securitizing everything as we securitized real estate it started to behave more and more like stocks and bonds you know how this manifests itself right 2008 was a terrible year for stocks a terrible year For Real Estate was a good year for bonds 2020 bad year for every all three what you now get is in years when your financial assets are doing badly your real estate is also doing badly and this is horrifically bad news for investors why because we all as investors need a safe place there are no safe

it used to be in the ' 80s the safe place was go to a foreign market they don't move with the us or buy real estate that doesn't move Where are you going to go every crisis I turn off my phone cuz people I don't know distant relatives can you tell me a safe place to put my money I feel like saying put it put all convert all into Cash put in a brown paper bag just mail it to me and maybe you see it for a couple of years from now maybe you won there

are no safe places left which is why every crisis now feels more terrifying you can sell things but where Are you going to put the money so in a sense you can see this play out in asset class and that's again the advantage you get once you make you could do this with historic risk premiums but you can see it with implied premiums so I've been selling this idea of an implied premium Now for 30 years with mixed success so I'll tell you how this usually goes you're going to you know go talk to equity

research analyst and Investment Bank man maning director will say you know what you know implied premium sounds good but we're okay I said what do you mean you're okay I said we all use the same premium and as long we use the same premium why does it matter whether the premium is right or wrong as long as the same premium let's play it out let's assume you're the managing director of an equity research group you all decide To use an 8.44 per premium that came from the historical risk premium stock versus Ste you picked a

just random number out of the table 8 point and everybody in your group uses 8.44 per. the implied premium is 4.33% so tell me what you're going to find each of you as your value company using an 8.44 per premium the Market's premium is 4.33% paa what's every person in this Group going to find when they value companies so you have a higher risk premium than you shirt what's it going to do to your discount rates they're going to make it higher they push down the value of every company so company a is going to

look over valued Company B is going to look overv valued company C is going to look overvalued 8.44 I can almost guarantee you that nothing in the US Equity Market is going to look cheap to you so what are you Going to do put sell recommendation sell recommendation sell recommendation next day you fire why you're an equity research analyst you can't be doing that so you know what analysts end up doing right because this happens all the time when investment Banks impose an equity risk premium that is higher than the current implied premium you need

to put byy recommendations you can't do much with the discount rate because it's already been pushed up so What do you do you play games and that's the only way to describe it with your growth rates and your cash flows you make up growth rates you push them up until you find enough there's really no point doing intrinsic valuation once you start going down that road but this is exactly where it starts so wherever you go to work if you something to do with valuation ask them what the equity risk premium is compute your own

implied Equity risk PR if it's Pretty close just let it go right you don't have to impose your premium if it's much higher you might want to bring that up as an issue we're overestimating the cost of equity and capital for every company that we value and our job is to Value companies we and if you go the other direction everything will look undervalued right too lower premium so even if an Enterprise doesn't use implied premiums knowing what it is will give you some Insight into why you're struggling so much trying to find undervalued companies

fact there is this mythology that intrinsic valuation most companies are going to look overvalue because the Market's so high what should your answer be to that if you're building an implied premium that reflects where the market is intrinsic valuation you should get balance right if everything is overvalued you can't blame the discount Rate that's not where the problem lies it has to be something about your forecast cash flows and growth that's driving it it brings the focus back on where it should be stories and cash flows and growth so every year I write this I

start in 2009 or 2008 for the I no 2009 for the first time I write this I'm I was going to call it a magnum opus but if this is my magnum opus I am in deep trouble I I write this thing on Everything I know about Equity risk premiums in I won't even call it P where it's a practitioner piece but it starts with historical so it takes through takes you through all these processes and at the end I say look now it's you said now she said he said we all come up with

different ways of estimating Equity risk premiums but there's a test to see whether the equity risk premium you're using is a good one which is if you do this right the equity risk premium you Come up with should be a good forecast of what the actual returns are in the following time period so I said that's a testable proposition I can use historical premiums I can use the earnings to price ratio I can use the the default spread and multiply by roughly two so I take all of these different and I run a I run

a race where I look to see which measure gives me the best predictive power for future rch so what do I want if I'm running a Correlation what do I want to see a high positive correlation right so I've taken four the the rest didn't even make the list but let's take take four you can take the current implied premium right now it's 4.27% you can smooth it out you can take an average implied premium which is a little higher 4.4 4.5% you can use a historical risk frame which is right now 5.44% you can

even take the default spread which right now is about 1.6 or 1.8% multiply by two roughly speaking that's what it's been historically and then I ran the correlations let's start with the worst possible way to estimate Equity risk premiums what am I looking for a large positive number this is about as terrible an estimate as you can get a historical risk premum not only is it the wrong sign it's cutting all the way so if you want a perverse estimate of equity risk Premiums keep using historical premiums it's going to cut in the wrong direction

it's going to give you high numbers when you should be using low low numbers when you should be using high and 90% of the world runs on historical risk premiums I was agnostic when I did this as to which implied premium I used to kind of experiment with averaging out smoothing out because you feel this thing I I'm smart I can figure out what what noise is and when you look at the numbers it Kind of brought me down to saying just use the current implied premium and you can see it on every measure you

know onee return 5e returns 10 year Returns the current applied premium does as well or better job than any of the other numbers so when people say why aren't you using on spray put that in the mix see what it does right essentially you're letting the market tell one final point for today and this is where I'm going to end the day and I Don't want this to end up on YouTube as my diet tribe against Indian Equity so don't put a know it'll end up in the actual video people might Slice It Anyway implied

premium what do I need I need the index level I need cash flows and I need a growth rate right can I get that for any Market yeah I don't need any history so this was a 2007 estimate I'll tell you what the 2025 number looks like where I tried to compute the implied Equity risk premium for the Sensex took the level of the index took the cash flows which are actually I used to I to estimate the I took just the dividends the problem with Indian stocks there's not much in BuyBacks and you can

use free cash Ro Equity if you feel the urge to do it but make your best judgment the growth rate was messy cuz like the S&P 500 where there are analysts forecasting earnings as far as I could tell there was no analyst in India who forecast earnings for the Entire sense they forecast for individual companies and for many of the companies they had only one year forecast companies which had adrs listed them trading you were able so I spliced and died together different growth rates and ended up with a growth rate of 14% all in

repeaters the risk fre rate in rupees was 6.76% I did exactly what I did with the S&P 500 as the index level there are cash flows so for the expected return The irr in India in 2007 was 11.18% subtract other risk fre rate the equity risk premium in India was two was 4.42% in India you know what that number looks like at the start of this year in India what's a sensex did done since 20073 quadrupled Maybe I know there's the India story working in the background and I push up growth I put all of

that in I even gave a 10-year growth rate because India is a Much more growth before it settles in the implied Equity risk premium came up for India was about 3 to 3 and a half% and let's step back right us premium is 4.33% you could probably buy German stocks and earn a 4 and a half% premium as a global investor you can tell me all the stories you want about India but if you're offering me a 3 and a half% premium I'm saying why would I invest in India that rais an interesting question why

would Indians invest in India because you have no choice it's true Indian investors you as an Indian as a US investor I don't like the way US stocks are priced you know what I can do I can pull all my money out of US Stocks buy ETFs in Germany and you know Europe wherever else I want I can move my money around if you're an Indian investor you don't like the way Indian stocks are price where are you Going to go I think there's a escape hatch which at least exists now didn't exist 20 years

ago $250,000 you can take out of the country you got to jump through all kinds of regulatory Hoops but the rest of the money stays in India and China is a variant of the same problem right if you're on in mainland China you can't exactly invest wherever you want without jumping through hoops and that's all it's actually a little better now than it was 40 years ago but 40 years ago nobody cared because as an economy India was small there wasn't much wealth to invest you could put all these barriers in and it's but as

both India and China have become wealthier this problem is just going to get bigger and right now it's all this money with no other place to go buying Asian paints at 55 times earning so that looks cheap to me because everything is relative yes be clear if you are Inv yes and there's a reason for that it goes back to Foreign Exchange controls in the old days where if money left India and you invested in dollar terms basically you had to convert your rupees to dollars so these were restrictions put in the 197s the 1960s

when foreign exchange was such a scarce resource that you have to hold on to every dollar UK could the problem now is not a foreign exchange issue it's how do you open these Escape hatches without creating Chaos let's was tomorrow the Indian government removed all restrictions and Indian investors went looking for stocks in Germany the US saying that's good for Indian investors but what it think of what it means for the Indian Equity market and Indian companies who've been coddled with now 20 years of really low cost of equity because they've got a captive market

right if I were the Indian government and I'm not thank God for that I'd figure out a way to start Opening these and the same thing with Chinese this is not going to get better it's not going to get easier to fix at least start moving in the right direction in opening up these Escape hatches because here's the most toxic thing that comes out of this right even Indians at some point in time would say let's say the premium drops to 3% 2.8 at some point you said this is too low for me so what

do you do you pull your money out of Stocks and you put it into something else the old days it used to be gold in real estate but guess what they've been run up as well I'm going to end up with a lot of Bitcoin holding Indians if you're not careful because they're going to go wherever they can go it's not healthy and it you can see the train wreck coming but India and China though have to do something about their train wreck I will talk to you on Wednesday so you get a week off

have fun but pick a Company work on while you're on vacation wherever you are um slightly inac from SL that you had so it's saying cash returns here it should be percentage Yeah the cash return should be the yeah that's that's no no what I'm saying is num cash return is not your disc yeah that equation was wrong I fixed it when I read it I [Music] Shoulder this is the Last 5 Years exactly how long looking for I all 127 you get a discount you get a discount we okay what I need to do

is you know any stud um I don't know so sorry the core business is one separate company yeah okay all Right you have you have to get a car and all thatu if you w have the choice for example we have insor have because in sit