I was boarding a plane for a trip to Latin America late in the evening last Wednesday (April 2), and as is my practice, I was checking the score on the Yankee game, when I read the tariff news announcement. Coming after a few days where the market seemed to have found its bearings (at least partially), it was clear from the initial reactions across the world that the breadth and the magnitude of the tariffs had caught most by surprise, and that a market markdown was coming. Not surprisingly, the markets opened down on Thursday and spent the next two days in that mode, with US equity indices declining almost 10% by close of trading on Friday. Luckily for me, I was too busy on both Thursday and Friday with speaking events, since as the speaker, I did not have the luxury (or the pain) of checking markets all day long. In my second venue, which was Buenos Aires, I quipped that while Argentina was trying its best to make its way back from chaos towards stability, the rest of the world was looking a lot more like Argentina, in terms of uncertainty. On Saturday, on a long flight back to New York, I wrestled with the confusion, denial and panic that come with a market meltdown, and tried to make sense of what had happened, and more importantly of what is coming. That thinking is still a work-in-progress but as in prior crises, I find that putting even unfinished thoughts down on paper (or in a post) is healthy, and perhaps a critical component to finding your way back to serenity. The Tariffs and Markets     Since talk of tariffs has filled the airwaves for most of this year, you may wonder why markets reacted so strongly to the announcement on Wednesday. One reason might have been that investors and businesses were not expecting the tariff hit to be as wide and as deep as they turned out to be.      Note that while Canada and Mexico were not on the Wednesday list of tariff targets that was released on Wednesday, they have been targeted separately, and that the remaining countries that do not show up on this map (Russia and North Korea, for instance) are under sanctions that prevent them from trading in the first place.      Another reason for the market reaction was that the basis for the tariff estimates, which have now been widely shared, are not easily fixable, since they are not based on tariffs imposed by other countries, but on the magnitude of the trade deficit of the United States with these countries. Thus, any country with which the US runs a significant trade deficit faces a large tariff, and smaller countries are more exposed than larger ones since the trade deficit is computed on a percentage basis, from exports and imports related to that country.  Thus, the easy out, where other countries offer to reduce or even remove their tariffs may have no or little effect on the tariffs, to the extent that the trade deficit may have little to do with tariffs.       Equities     The extent of the market hit can be seen by looking at the major US equity indices, the Dow, the S&P 500 and the NASDAQ, all of which shed significant portions of their value on Thursday and Friday: Looking beyond these indices and across the globe, the negative reaction has been global, as can be seen in the returns to equity across sub-regions, with all returns denominated in US dollars: The worst hit regions of the world is Small Asia, which is Asia not counting India, China and Japan, which saw equity values in the aggregate decline by 12.61% in the last week. US equities had the biggest decline in dollar value terms, losing $5.3 trillion in value last week, a 9.24% decline in value from the Friday close on March 28, 2025. China and India have held up the best in the last week, perhaps because both countries have large enough domestic markets to sustain them through a trade war. It is also a factory that with time differences, these markets both closed before the Friday beatdown on Wall Street unfolded, and the open on Monday may give a better indication of the true reaction. Breaking down just US equities, by sector, we can see the damage across sectors: The technology sector lost the most in value last week, both in dollar terms, shedding almost $1.8 trillion (and 11.6%) in equity value, and consumer staples and utilities held up the best, dropping 2.30% and 4.40% respectively. In percentage terms, energy stocks have lost the most in value, with market capitalizations dropping by 14.2%, dragged down by declining oil prices.     Staying with US equities, and breaking down companies, based upon their market capitalizations coming into 2025, we can again see write downs in equity value across the spectrum from last week's sell off: As you can see, it looks like there is little to distinguish across the market cap spectrum, as the pain was widely distributed across the market cap classes, with small and large companies losing roughly the same percent of value. To the extent that market crisis usually cause a flight to safety, I looked at US stocks, broken down by decile into earnings yield (Earnings to price ratios), over the last week: The lowest earnings to price ratio (highest PE) stocks, in the aggregate, lost 10.91% of their market capitalization last week, compared to the 8.08% decline in market cap at the highest earnings to price (lowest PE ratio) companies, providing some basis for the flight to safety hypothesis. Staying with the safety theme, I looked at US companies, broken down by debt burden (measured as debt to EBITDA): On this dimension, the numbers actually push against the flight to safety hypothesis, since the companies with the least debt performed worse than those with the most debt. Finally, I looked at whether dividend paying and cash returning companies were better protected in the sell off, by looking at dividend paying (buying back stock) companies versus non-dividend paying (not buying back stock) companies: While dividend paying stocks did drop by less than non-dividend paying stocks, companies buying back stock underperformed those that did not buy back stock in 2024.        If you came into last week, believing that stocks were over priced, you would expect the correction to be worse at companies that have been bid up the most, and to test this, I classified US stocks based upon percentage stock price performance in 2024: While the worst performers from last year came into the week down only 1.83% through March 28, whereas the best performers from 2024 were down 6.46% over the same period, there was little to distinguish between the two groups last week.      Finally, I looked at the Mag Seven stocks, since they have, in large part, carried US equities for much of the last two years; Collectively, the Mag Seven came into last last week, already down 14.79% for the year (2025), but their losses last week, which massive in dollar value terms ($1.55 trillion) were close in percentage terms to the losses in the rest of the market. Other Markets     As equity markets reacted to the tariff announcement, other markets followed. US treasury rates, which had entered the week down from the start of the year, continued to decline during the course of the week: While the 3-month treasury bill rate remained fairly close to what it was at the start of the week, the rates at the longer end, from 2-year to 30-year all saw drops during the week, perhaps reflecting a search for safety on the part of investors. The drops, at least so far, have been modest and much smaller than what you would expect from a market sell off, where US equities dropped by $5.3 trillion.     Looking past financial markets, I focused on three diverse markets - the oil market as a stand-in for commodity markets overall, the gold market, representing the time-tested collectible, and Bitcoin, which is perhaps the millennial version of gold: Oil prices dropped last week, especially as financial asset markets melted down on Thursday and Friday, while both gold and bitcoin held their own last week. For bitcoin advocates, that is good news, since in other market crises since its creation, it has behaved more like risky stock than a collectible. Of course, it I still early in this crisis, and the true tests will come in the next few weeks.   Summing up     In sum, the data seems to point more to a mark down in equity values than to panic selling, at least based upon the small sample of two days from last week. There was undoubtedly some panic selling on Friday, but the flight to safety, whether it be in moving into treasuries or high dividend paying stocks, was muted.    The Crisis Cycle     Each crisis is unique both in its origins and in how it plays out, but there is still value in looking across crises, to see how they unfold, what causes them to crest, and how and why they recede. In this section, I will present a crisis cycle, which almost every crisis works its way through, with big differences in how quickly, and with how much damage. The crisis cycle starts with a trigger event, which can be economic, political or financial, though there are often smaller events ahead of is occurrence that point to its coming. The immediate effect is in markets, where investors respond with the only instrument the they control, which is the prices they pay for assets, which they mark down to reflect at least their initial response to the crisis. In the language of risk, they are demanding higher prices for risk, translating into higher risk premiums. In conjunction, they often move their money to safer assets, with treasuries and collectibles historically benefiting from the fund flows. In the days and weeks that follow, there are aftershocks from the trigger event, both on the news and the market fronts, and while these aftershocks can sometimes be positive for markets, the net effect is usually negative. The effects find their way into the real economy, as consumers and businesses pull back, causing an economic slowdown or a recession, with negative effects on earnings and cash flows, at least in the near term. In the long term, the trigger event can change the economic dynamics, causing a resetting of real growth and inflation expectations, which then feed back into markets; To illustrate, consider the 2008 banking crisis, where the Lehman collapse over the weekend before September 15 triggered a sell off in the stock market that caused equities to drop by 28% between September 12 and December 31, 2008, and triggered a steep recession, causing unemployment to hit double digits in 2009. The earnings for S&P 500 companies took a 40% hit in 2008, and long term, neither the economy nor earnings recovered back to pre-crisis levels until 2012. During that crisis, I started a practice of estimating equity risk premiums by day, reflecting my belief that it is day-to-day movements in the price of risk that cause equity markets to move as much as they do in a crisis: Spreadsheet with raw data Equity risk premiums which started the crisis at around 4% peaked at almost 8% on November 21, 2008, before ending the year at 6.43%, well above the levels at the start of 2008. Those equity risk premiums did not get back to pre-2008 levels until almost 15 years later.     Moving to 2020 and looking at the COVID crisis, the trigger event was a news story out of Italy about COVID cases in the country that could not be traced to either China or cruise ships, shattering the delusion that the pandemic would be contained to those settings. In the weeks after, the S&P 500 shed 33% of its value before bottoming out on March 23, 2020, and treasury rates plunged to historic lows, hitting 0.76% on that day. The key difference from 2008 was that the damage to the economy and earnings was mostly short term, and by the end of the year, both (economy and earnings) were on the mend, helped undoubtedly by multi-trillion dollar government support and central banking activism: As in 2008, I computed equity risk premiums by day all through 2020, and the graph below tells the story: Spreadsheet with raw data As you can see, the equity risk premium which started at 4.4% on February 14, 2020, peaked a few weeks later at 7.75% on March 23, 2020, and as with the economy and earnings, it was back down to pre-crisis levels by September 2020. The Perils of Post Mortems     Each crisis gives rise to postmortems, where investors, regulators and researchers pore over the data, often emerging with conclusions that extrapolate too much from what happened. For investors: The lesson that many investors get out of looking at past crises is that markets come back from even the worst meltdowns, and that contrarian investing with a long time horizon always works. While that may be comforting, this lesson ignores the reality that the fact that a catastrophe did not occur in the crisis in question does not imply that the probability of it occurring was always zero. Markets assess risks in real time. For regulators: To the extent that crises expose the weakest seams in markets and businesses, regulators often come in with fixes for those seams, mostly by dealing with the symptoms, rather than the causes. After the 2008 crisis, the conclusions were that the problems was banks behaving badly and ratings agencies that were not doing their job, both merited judgments, but the question of risk incentives that had led them on their risk taking misadventures were largely left untouched. For researchers: With the benefit of hindsight, regulators weave stories about crises that are built around their own priors, by selectively picking up data items that support them. Thus, behavioral economists find every crisis to be an example of bubbles bursting and corrections for irrational investing, and efficient market theorists use the same crisis as an illustration of the magic of markets working. It is worth remembering that each crisis is a sample size of one, and since each crises is different, aggregating or averaging across them can be difficult to do. Thus, the danger is that we try to learn too much from past crises rather than too little. The Tariff Crisis?     I don't believe that it is premature to put the tariff news and reaction into the crisis category. It has the potential to change the global economic order, and a market reaction is merited. It is, however, early in the process, since we are just past the trigger event (tariff announcement) and the initial market reaction, with lots of unknowns facing us down the road: There are clearly stages of this crisis that have played out, but based on what we know now, here is how I see them: After shocks: The tariff story will have after shocks, with both negatives (other countries imposing their own tariffs, and the US responding) and positives (a pause in tariffs, countries dropping tariffs). Those after shocks will create more market volatility, and if history is any guide, there is more downside than upside in the near term. In addition, the market volatility can feed itself, as levered investors are forced to close out positions and fund flows to markets reflect investor concerns and uncertainty. If you add on top of that the possibility that global investors may decide to reduce their US equity holdings, that reallocation will have price effects. Real economy (near term): In the near term, the real economy will slow down, with the plus being that while tariff-related price increases are coming, a cooling down in the economy will dampen inflation. The likelihood of a recession has spiked in the days since the tariff announcement, and while we will have to wait for the numbers on real growth and unemployment to come in, it does look likely that real growth will be impacted negatively. The steep declines in commodity prices suggests that investors see an economic slowdown on the horizon. As Real economy (long term): Global economic growth will slow, and the US, as the world’s largest economy, will slow with it.. There are other dynamics at play including a restructuring of old economic and political alliances (Is there a point to having a G7 meeting?) and a new more challenging environment for global companies that have spent the last few decades building supply chains that stretch across the globe, and selling to consumers all over. It is worth noting that if we measure winning by not the size of the pie (the size of the entire economy) but who gets what slice of that economy, it is possible that tariffs could reapportion the pie, with capital (equity markets) getting a smaller slice, and workers getting a larger slice,. In fact, much of this administration's defense of the tariff has been on this front, and time will tell whether that works out to be the case.     In the two days after the announcement, stock prices have dropped and the price of risk has risen, as investors reassess the economy and markets: The implied equity risk premium has risen from 4.57% on April 2  to 5.08% by the close of trading on Friday. The road ahead of us is long, but I plan to continue to compute these implied equity risk premiums every day for as long as I believe we are in crisis-mode, and I will keep these updated numbers on my webpage. As stocks have been revalued with higher prices of risk, that same uncertainty is playing out in the corporate bond market, where corporate default spreads widened on Thursday (April 3) and Friday (April 4): As with the equity risk premiums, the price of risk in the bond market had already risen between the start of 2025 and March 28, 2025, but they surged last week, with the lowest ratings showing the biggest surges. With treasury rates, equity risk premiums and default spreads all on the move it may be time for companies and investors to be reassessing their costs of equity and capital.  What now?     If you have stayed with me so far on this long and rambling discourse, you are probably looking for my views on how this crisis will unfold, and how investors should respond now. I am afraid that dishing out investment advice is not my cup of tea, but I will try to explain how I plan to deal with what's coming, with the caveat that what I do may not work for you A (Personal) Postscript      In the midst of every market meltdown, you will see three groups of experts emerge. The first will be the "I told you so" group, eager to tell you that this is the big one, the threat that they have spent a decade or more warning you about. They will of course not let on that if you had followed their advice from inception, you would have been invested in cash for the last decade, and even with a market crash, you would not be made hold again. The second will include "knee jerk contrarians", arguing that stock markets always come back, and that every market dip is a buying opportunity, an extraordinarily lazy philosophy that gets the rewards (none) that its deserves. The third will be the "indecisives", who will present every side of the argument, conclude that there is too much uncertainty right now to either buy or sell, but to wait until the uncertainty passes. There are elements of truth in all three arguments, but they all have blind spots.     In the midst of a crisis, the market becomes a pricing game, where perception gets the better of reality, momentum overwhelms fundamentals and day-to-day movements cannot be rationalized. Anyone who tells you that their crystal balls, data or charts can predict what's coming is lying or delusional, and there is no one right response to this (or any other) crisis. It will depend on: Cash needs and time horizon: If you are or will soon be in need of cash, to pay for health care, buy a home or pay tuition, and you are invested in equities, you should take the cash out now. Waiting for a better time to do so, when the clock is ticking is the equivalent of paying Russian Roulette and just as dangerous. Conversely, if you do not need the cash and are patient, you have the flexibility of waiting, though having a longer time horizon does not necessarily mean that you should wait to act. Macro views: The effects on markets and the real economy will depend on how you see the tariffs playing out, with the outcomes ranging from a no-holds-barred trade war (with tariffs and counter tariffs) to a partial trade war (with some countries capitulating and others fighting) to a complete clearing of the air (where the tariff threat is scaled down or put on the back burner). While you may be inclined to turn this over to macro economists, this is less about economics and more about game theory, where an expert poker player will be better positioned to forecast what will happen than an economic think tank. Investment philosophy: I have long argued (and teach a class to that effect) that every investor needs an investment philosophy, attuned to his or her personal make up. That philosophy starts with a set of beliefs about how markets make mistakes and corrects them, and manifests in strategies designed to take advantage of those mistakes.  My investment philosophy starts with the belief that markets, for the most part, do a remarkable job in aggregating and reflecting crowd consensus, but that they sometimes make big  mistakes that take long periods to correct, especially in periods and portions of the market where there is uncertainty.  I am terrible at gauging market mood and momentum, but feel that I have an edge (albeit a small one) in assessing individual companies, though that may be my delusion. My response to this crisis (or any other) will follow this script: Daily ERP: As in prior crises, I will continue to monitor the equity risk premiums, treasury rates and the expected return on stocks every day until I feel comfortable enough to let go. Note that this process lasted for months after the 2008 and 2020 crises, but as earnings updates for the S&P 500 reflect tariffs, my confidence in my assessments will increase. (As mentioned earlier, you will find these daily updates at this link) Revalue companies in my portfolio: While I was comfortable with the companies in my portfolio on March 28, viewing them as under valued or at least not over valued enough to merit a sell, the tariffs may have an significant effect on their values, and I plan to revalue them in batches, starting with my big tech holdings (the Mag Five, since I did sell Tesla and most of my Nvidia holdings) and working through the rest.  Buy value: I have drawn a contrast between great companies and great investments, with the former characterized by large moats, great management and strong earnings power, and the latter by being priced too low. There are companies that I believe are great companies, but are priced so highly by the market that they are sub-standard investments and I choose not to invest in them. During a crisis, where investors often sell without discrimination, there companies can become buys, and I have to be ready to buy at the right price. Since buying in the face of a market meltdown can require fortitude that I may not have, I have been scouring my list of great companies, revaluing them with the tariff effects built in, and putting buys at limit prices below those values. In the last week, both BYD, a company that I said that I liked, a few weeks ago in my post on globalization and disruption, and Mercado Libre, a Latin American powerhouse, that has the disruptive potential of an Amazon combined with a fintech enterprise, have moved from being significantly overvalued to within shouting distance of the limit prices I have on them.  Go back to living: I certainly don't see much gain watching the market hour-to-hour and day-to-day, since its doings are out of my control and anything that I do in response is more likely to do harm than good. Instead, I plan on living my life, enjoying life's small pleasures, like a Yankee win or taking my dog for a walk, to big ones, like celebrating my granddaughter's birthday in a couple of days.  I hope that you find your own path back to serenity in the face of this market volatility, and that whatever you end up doing with your portfolio allows you to pass the sleep test, where you don't lie awake at night thinking about your portfolio (up or down).  YouTube Video Data Links Equity risk premiums by day, Banking Crisis in 2008 Equity risk premiums by day, COVID Crisis in 2020 Equity risk premiums by day, Tariff Crisis in 2025 (ongoing)

In my ninth (and last) data post for 2025, I look at cash returned by businesses across the world, looking at both the magnitude and the form of that return. I start with a framework for thinking about how much cash a business can return to its owners, and then argue that, in the real world, this decision is skewed by inertia and me-tooism. I also look at a clear and discernible shift away from dividends to stock buybacks, especially in the US, and examine both good and bad reasons for this shift. After reporting on the total cash returned during the year, by public companies, in the form of dividends and buybacks, I scale the cash returned to earnings (payout ratios) and to market cap (yield) and present the cross sectional distribution of both statistics across global companies. The Cash Return Decision     The decision of whether to return cash, and how much to return, should, at least in principle, be the simplest of the three corporate finance decisions, since it does not involve the estimation uncertainties that go with investment decisions and the angst of trading of tax benefits against default risk implicit in financing decisions. In practice, though, there is probably more dysfunctionality in the cash return decision, than the other two, partly driven by deeply held, and often misguided views, of what returning cash to shareholders does or does not do to a business, and partly by the psychology that returning cash to shareholders is an admission that a company's growth days are numbered. In this section, I will start with a utopian vision, where I examine how cash return decisions should play out in a business and follow up with the reality, where bad dividend/cash return decisions can drive a business over a cliff.  The Utopian Version     If, as I asserted in an earlier post, equity investors have a claim the cash flows left over after all needs (from taxes to debt payments to reinvestment needs) are met, dividends should represent the end effect of all of those choices. In fact, in the utopian world where dividends are residual cash flows, here is the sequence you should expect to see at businesses: In a residual dividend version of the world, companies will start with their cash flows from operations, supplement them with the debt that they think is right for them, invest that cash in good projects and the cash that is left over after all these needs have been met is available for cash return. Some of that cash will be held back in the company as a cash balance, but the balance can be returned either as dividends or in buybacks. If companies following this sequence to determine, here are the implications: The cash returned should not only vary from year to year, with more (less) cash available for return in good (bad) years), but also across firms, as firms that struggle on profitability or have large reinvestment needs might find that not only do they not have any cash to return, but that they might have to raise fresh capital from equity investors to keep going.  It also follows that the investment, financing, and dividend decisions, at most firms, are interconnected, since for any given set of investments, borrowing more money will free up more cash flows to return to shareholders, and for any given financing, investing more back into the business will leave less in returnable cash flows.      Seen through this structure, you can compute potential dividends simply by looking for each of the cash flow elements along the way, starting with an add back of depreciation and non-cash charges to net income, and then netting out investment needs (capital expenditures, working capital, acquisitions) as well as cash flow from debt (new debt) and to debt (principal repayments).  While this measure of potential dividend has a fanciful name (free cash flow to equity), it is not only just a measure of cash left in the till at the end of the year, after all cash needs have been met, but one that is easy to compute, since every items on the list above should be in the statement of cash flows.     As with almost every other aspect of corporate finance, a company's capacity to return cash, i.e., pay potential dividends will vary as it moves through the corporate life cycle, and the graph below traces the path: There are no surprises here, but it does illustrate how a business transitions from being a young company with negative free cash flows to equity (and thus dependent on equity issuances) to stay alive to one that has the capacity to start returning cash as it moves through the growth cycle before becoming a cash cow in maturity. The Dysfunctional Version     In practice, though, there is no other aspect of corporate finance that is more dysfunctional than the cash return or dividend decision, partly because the latter (dividends) has acquired characteristics that get in the way of adopting a rational policy. In the early years of equity markets, in the late 1800s,  companies wooed investors who were used to investing in bonds with fixed coupons, by promising them predictable dividends as an alternative to the coupons. That practice has become embedded into companies, and dividends continue to be sticky, as can be seen by the number of companies that do not change dividends each year in the graph below: While this graph is only of US companies, companies around the world have adopted variants of this sticky dividend policy, with the stickiness in absolute dividends (per share) in much of the world, and in payout ratios in Latin America. Put simply, at most companies, dividends this year will be equal to dividends last year, and if there is a change, it is more likely to be an increase than a decrease.     This stickiness in dividends has created several consequences for firms. First, firms are cautious in initiating dividends, doing so only when they feel secure in their capacity to keep generate earnings. Second, since the punishment for deviating from stickiness is far worse, when you cut dividends, far more firms increase dividends than decrease them. Finally, there are companies that start paying sizable dividends, find their businesses deteriorate under them and cannot bring themselves to cut dividends. For these firms, dividends become the driving force, determining financing and investment decisions, rather than being determined by them. This is, of course, dangerous to firm health, but given a choice between the pain of announcing a dividend suspension (or cut) and being punished by the market and covering up operating problems by continuing to pay dividends, many managers choose the latter, laying th e pathway to dividend madness. Dividends versus Buybacks      As for the choice of how to return that cash, i.e., whether to pay dividends or buy back stock, the basics are simple. Both actions (dividends and buybacks) have exactly the same effect on a company’s business picture, reducing the cash held by the business and the equity (book and market) in the business. It is true that the investors who receive these cash flows may face different tax consequences and that while neither action can create value, buybacks have the potential to transfer wealth from one group of shareholders (either the ones that sell back or the ones who hold on) to the other, if the buyback price is set too low or too high.         It is undeniable that companies, especially in the United States, have shifted away from a policy of returning cash almost entirely in dividends until the early 1980s to one where the bulk of the cash is returned in buybacks. In the chart below, I show this shift by looking at the aggregated dividends and buybacks across S&P 500 companies from the mid-1980s to 2024: While there are a number of reasons that you can point to for this shift, including tax benefits to investors, the rise of management options and shifting tastes among institutional investors, the primary reason, in my view, is that sticky dividends have outlived their usefulness, in a business age, where fewer and fewer companies feel secure about their earning power. Buybacks, in effect, are flexible dividends, since companies, when faced with headwinds, quickly reduce or cancel buybacks, while continuing to pay dividends: In the table below, I look at the differences between dividends and buybacks: If earnings variability and unpredictability explains the shifting away from dividends, it stands to reason that this will not just be a US phenomenon, and that you will see buybacks increase across the world. In the next section, we will see if this is happening.     There are so many misconceptions about buybacks that I did write a piece that looks in detail at those reasons. I do want to reemphasize one of the delusions that both buyback supporters and opponents use, i.e., that buybacks create or destroy value. Thus, buyback supporters argue that a company that is buying back its own shares at a price lower than its underlying value, is effectively taking an investment with a positive net present value, and is thus creating value. That is not true, since that action just transfers value from shareholders who sell back (at the too low a price) to the shareholders who hold on to their shares. Similarly, buyback opponents note that many companies buy back their shares, when their stock prices hit new highs, and thus risk paying too high a price, relative to value, thus destroying value. This too is false, since paying too much for shares also is a wealth transfer, this time from those who remain shareholders in the firm to those who sell back their shares.  Cash Return in 2024     Given the push and pull between dividends as a residual cash flow, and the dysfunctional factors that cause companies to deviate from this end game, it is worth examining how much companies did return to their shareholders in 2024, across sectors and regions, to see which forces wins out. Cash Return in 2024     Let's start with the headline numbers. In 2024, companies across the globe returned $4.09 trillion in cash to their shareholders, with $2.56 trillion in dividends and $1.53 trillion taking the form of stock buybacks. If you are wondering how the market can withstand this much cash being withdrawn, it is worth emphasizing an obvious, but oft overlooked fact, which is that the bulk of this cash found its way back into the market, albeit into other companies. In fact, a healthy market is built on cash being returned by some businesses (older, lower growth) and being plowed back into growth businesses that need that capital.     That lead in should be considered when you look at cash returned by companies, broken down by sector, in the table below, with the numbers reported both in US dollars and scaled to the earnings at these companies: To make the assessment, I first classified firms into money making and money losing, and aggregated the dividends and buybacks for each group, within each sector.  Not surprisingly, the bulk of the cash bering returned is from money making firms, but the percentages of firms that are money making does vary widely across sectors. Utilities and financials have the highest percentage of money makers on the list, and financial service firms were the largest dividend payers, paying $620.3 billion in dividends in 2024, followed by energy ($346.2 billion) and industrial ($305.3 billion). Scaled to net income, dividend payout ratios were highest in the energy sector and technology companies had the lowest payout ratios. Technology companies, with $280.4 billion, led the sectors in buybacks, and almost 58% of the cash returned at money making companies in the sector took that form.     Breaking down global companies by region gives us a measure of variation on cash return across the world, both in magnitude and in the type of cash return: It should come as no surprise that the United States accounted for a large segment (more than $1.5 trillion) of cash returned by all companies, driven partly by a mature economy and partly by a more activist investor base, and that a preponderance of this cash (almost 60%) takes the form of buybacks. Indian companies return the lowest percentage (31.1%) of their earnings as cash to shareholders, with the benign explanation being that they are reinvesting for growth and the not-so-benign reason being poor corporate governance. After all, in publicly traded companies, managers have the discretion to decide how much cash to return to shareholders, and in the absence of shareholder pressure, they, not surprisingly, hold on to cash, even if they do not have no need for it. It is also interesting that buybacks seems to be making inroads in other paths of the world, with even Chinese companies joining the party. FCFE and Cash Return     While it is conventional practice to scale dividends to net income, to arrive at payout ratios, we did note, in the earlier section, that you can compute potential dividends from financial statements, Here again, I will start with the headline numbers again. In 2024, companies around the world collectively generated $1.66 trillion in free cash flows to equity: As you can see in the figure, companies started with net income of $6,324 billion, reinvested $4,582 billion in capital expenditures and debt repayments exceeded debt issuances by $90 billion to arrive at the free cash flow to equity of $1.66 trillion. That said, companies managed to pay out $2,555 billion in dividends and bought back $1,525 billion in stock, a total cash return of almost $4.1 trillion.     As the aggregate numbers indicate, there are many companies with cash return that does not sync with potential dividends or earnings. In the picture below, we highlight four groups of companies, with the first two focused on dividends, relative to earnings, and the other two structured around cash returned relative to free cash flows to equity, where we look at mismatches. Let's start with the net income/dividend match up. Across every region of the world, 17.5% of money losing companies continue to pay dividends, just as 31% of money-making companies choose not to pay dividends. Using the free cash flows to equity to divide companies, 38% of companies with positive FCFE choose not to return any cash to their shareholder while 48% of firms with negative FCFE continue to pay dividends. While all of these firms claim to have good reasons for their choices, and I have listed some of them, dividend dysfunction is alive and well in the data.     I argued earlier in this post that cash return policy varies as companies go through the life cycle, and to see if that holds, we broke down global companies into deciles, based upon corporate age, from youngest to oldest, and looked at the prevalence of dividends and buybacks in each group: As you can see, a far higher percent of the youngest companies are money-losing and have negative FCFE, and it is thus not surprising that they have the lowest percentage of firms that pay dividends or buy back stock. As companies age, the likelihood of positive earnings and cash flows increases, as does the likelihood of dividend payments and stock buybacks. Conclusion     While dividends are often described as residual cash flows, they have evolved over time to take on a more weighty meaning, and many companies have adopted dividend policies that are at odds with their capacity to return cash. There are two forces that feed this dividend dysfunction. The first is inertia, where once a company initiates a dividend policy, it is reluctant to back away from it, even though circumstances change. The second is me-tooism, where companies adopt cash return policies to match  their peer groups, paying dividends because other companies are also paying dividends, or buying back stock for the same reasons. These factors explain so much of what we see in companies and markets, but they are particularly effective in explaining the current cash return policies of companies. YouTube Data Updates for 2025 Data Update 1 for 2025: The Draw (and Danger) of Data! Data Update 2 for 2025: The Party continued for US Equities Data Update 3 for 2025: The times they are a'changin'! Data Update 4 for 2025: Interest Rates, Inflation and Central Banks! Data Update 5 for 2025: It's a small world, after all! Data Update 6 for 2025: From Macro to Micro - The Hurdle Rate Question! Data Update 7 for 2025: The End Game in Business! Data Update 8 for 2025: Debt, Taxes and Default - An Unholy Trifecta! Data Update 9 for 2025: Dividend Policy - Inertia and Me-tooism Rule! Data Links Dividend fundamentals, by industry (US, Global, Emerging Markets, Europe, Japan, India, China) Cash return and FCFE, by industry (US, Global, Emerging Markets, Europe, Japan, India, China)

There is a reason that every religion inveighs against borrowing money, driven by a history of people and businesses, borrowing too much and then paying the price, but a special vitriol is reserved for the lenders, not the borrowers, for encouraging this behavior. At the same time, in much of the word, governments have encouraged the use of debt, by providing tax benefits to businesses (and individuals) who borrow money. In this post, I look at the use of debt by businesses, around the globe, chronicling both the magnitude of borrowing, and the details of debt (in terms of maturity, fixed vs floating, straight vs convertible). The tension between borrowing too little, and leaving tax benefits on the table, and borrowing too much, and exposing yourself to default risk, is felt at every business, but the choice of how much to borrow is often driven by a range of other considerations, some of which are illusory, and some reflecting the frictions of the market in which a business operates. The Debt Trade off     As a prelude to examining the debt and equity tradeoff, it is best to first nail down what distinguishes the two sources of capital. There are many who trust accountants to do this for them, using whatever is listed as debt on the balance sheet as debt, but that can be a mistake, since accounting has been guilty of mis-categorizing and missing key parts of debt. To me, the key distinction between debt and equity lies in the nature of the claims that its holders have on cash flows from the business. Debt entitles its holders to contractual claims on cash flows, with interest and principal payments being the most common forms, whereas equity gives its holders a claim on whatever is left over (residual claims). The latter (equity investors) take the lead in how the business is run, by getting a say in choosing who manages the business and how it is run, while lenders act, for the most part, as a restraining influence. Using this distinction, all interest-bearing debt, short term and long term, clears meets the criteria for debt, but for almost a century, leases, which also clearly meet the criteria (contractually set, limited role in management) of debt, were left off the books by accountants. It was only in 2019 that the accounting rule-writers (IFRS and GAAP) finally did the right thing, albeit with a myriad of rules and exceptions.      Every business, small or large, private or public and anywhere in the world, faces a question of whether to borrow money, and if so, how much, and in many businesses, that choice is driven by illusory benefits and costs. Under the illusory benefits of debt, I would include the following: Borrowing increases the return on equity, and is thus good: Having spent much of the last few decades in New York, I have had my share of interactions with real estate developers and private equity investors, who are active and heavy users of debt in funding their deals. One reason that I have heard from some of them is that using debt allows them to earn higher returns on equity, and that it is therefore a better funding source than equity. The first part of the statement, i.e., that borrowing money increases the expected return on equity in an investment, is true, for the most part, since you have to contribute less equity to get the deal done, and the net income you generate, even after interest payments, will be a higher percentage of the equity invested. It is the second part of the statement that I would take issue with, since the higher return on equity, that comes with more debt, will be accompanied by a higher cost of equity, because of the use of that debt. In short, I would be very skeptical of any analysis that claims to turn a neutral or bad project, funded entirely with equity, into a good one, with the use of debt, especially when tax benefits are kept out of the analysis. The cost of debt is lower than the cost of equity: If you review my sixth data update on hurdle rates, and go through my cost of capital calculation, there is one inescapable conclusion. At every level of debt, the cost of equity is generally much higher than the cost of debt for a simple reason. As the last claimants in line, equity investors have to demand a higher expected return than lenders to break even. That leads some to conclude, wrongly, that debt is cheaper than equity and more debt will lower the cost of capital. (I will explain why later in the post.) Under the illusory costs of debt, here are some that come to mind: Debt will reduce profits (net income): On an absolute basis, a business will become less profitable, if profits are defined as net income, if it borrows more money. That additional debt will give rise to interest expenses and lower net income. The problem with using this rationale for not borrowing money is that it misses the other side of debt usage, where using more debt reduces the equity that you will have to invest. Debt will lower bond ratings: For companies that have bond ratings, many decisions that relate to use of debt will take into account what that added debt will do to the company’s rating. When companies borrow more money, it may seem obvious that default risk has increased and that ratings should drop, because that debt comes with contractual commitments. However, remember that the added debt is going into investments (projects, joint ventures, acquisitions), and these investments will generate earnings and cash flows. When the debt is within reasonable bounds (scaling up with the company), a company can borrow money, and not lower its ratings. Even if bond ratings drop, a business may be worth more, at that lower rating, if the tax benefits from the debt offset the higher default risk. Equity is cheaper than debt: There are businesspeople (including some CFOs) who argue that debt is cheaper than equity, basing that conclusion on a comparison of the explicit costs associated with each – interest payments on debt and dividends on equity. By that measure, equity is free at companies that pay no dividends, an absurd conclusion, since investors in equity anticipate and build in an expectation of price appreciation. Equity has a cost, with the expected price appreciation being implicit, but it is more expensive than debt. The picture below captures these illusory benefits and costs: If the above listed are illusory reasons for borrowing or not borrowing, what are the real reasons for companies borrowing money or not borrowing? The two primary benefits of borrowing are listed below: Tax Benefits of Debt: The interest expenses that you have on debt are tax deductible in much of the world, and that allows companies that borrow money to effectively lower their cost of borrowing:      After-tax cost of debt = Interest rate on debt (1 – tax rate)  In dollar terms, the effect is similar; a firm with a 25% tax rate and $100 million in interest expenses will get a tax benefit of $25 million, from that payment.   Debt as a disciplinary mechanism: In some businesses, especially mature ones with lots of earnings and cash flows, managers can become sloppy in capital allocation and investment decisions, since their mistakes can be covered up by the substantial earnings. Forcing these companies to borrow money, can make managers more disciplined in project choices, since poor projects can trigger default (and pain for managers). These have to be weighted off against two key costs: Expected bankruptcy costs: As companies borrow money, the probability that they will be unable to make their contractual payments on debt will always increase, albeit at very different rtes across companies, and across time, and the expected bankruptcy cost is the product of this probability of default and the cost of bankruptcy, including both direct costs (legal and deadweight) and indirect costs (arising from the perception that the business is in trouble). Agency costs: Equity investors and lenders both provide capital to the business, but the nature of their claims (contractual and fixed for debt versus residual for equity) creates very different incentives for the two groups. In short, what equity investors do in their best interests (taking risky projects, borrow more money or pay dividends) may make lenders worse off. As a consequence, when lending money, lenders write in covenants and restrictions on the borrowing businesses, and those constraints will cause costs (ranging from legal and monitoring costs to investments left untaken). The real trade off on debt is summarized in the picture below: While the choices that businesses make on debt and equity should be structured around expected tax benefits (debt’s biggest plus) and expected bankruptcy costs (debt’s biggest minus), businesses around the world are affected by frictions, some imposed by the markets that they operate in, and some self-imposed. The biggest frictional reasons for borrowing are listed below: Bankruptcy protections (from courts and governments): If governments or courts step in to protect borrowers, the former with bailouts, and the latter with judgments that consistently favor borrowers, they are nullifying the effect of expected bankruptcy costs in restraining companies from borrowing too much. Consequently, companies in these environments will borrow much more than they should. Subsidized Debt: If lenders or governments lend money to firms at below-market reasons for reasons of virtue (green bonds and lending) or for political/economic reasons (governments lending to companies that choose to keep their manufacturing within the domestic economy), it is likely that companies will borrow much more than they would have without these debt subsidies. Corporate control: There are companies that choose to borrow money, even though debt may not be the right choice for them, because the inside investors in these companies (family groups, founders) do not want to raise fresh equity from the market, concerned that the new shares issued will reduce their power to control the firm.  The biggest frictional reasons for holding back on borrowing include: Debt covenants: To the extent that debt comes with restrictions, a market where lender restrictions are more onerous in terms of the limits that they put on what borrowers can or cannot do will lead to a subset of companies that value flexibility borrowing less. Overpriced equity: To the extent that markets may become over exuberant about a company's prospects, and price its equity too highly, they also create incentives for these firms to overuse equity (and underutilize debt).  Regulatory constraints: There are some businesses where governments and regulators may restrict how much companies operating in them can borrow, with some of these restrictions reflecting concerns about systemic costs from over leverage and others coming from non-economic sources (religious, political). The debt equity trade off, in frictional terms, is in the picture below: As you look through these trade offs, real or frictional, you are probably wondering how you would put them into practice, with a real company, when you are asked to estimate how much it should be borrow, with more specificity. That is where the cost of capital, the Swiss Army Knife of finance that I wrote about in my sixth data update update, comes into play as a debt optimizing tool. Since the cost of capital is the discount rate that you use to discount cash flows back to get to a value, a lower cost of capital, other things remaining equal, should yield a higher value, and minimizing the cost of capital should maximize firm. With this in place, the “optimal” debt mix of a business is the one that leads to the lowest cost of capital: You will notice that as you borrow more money, replacing more expensive equity with cheaper debt, you are also increasing the costs of debt and equity, leading to a trade off that can sometimes lower the cost of capital and sometimes increase it. This process of optimizing the debt ratio to minimize the cost of capital is straight forward, and if you are interested, this spreadsheet will help you do this for any company. Measuring the Debt Burden     With that tradeoff in place, we are ready to examine how it played out in 2024, by looking at how much companies around the world borrowed to fund their operations. We can start with dollar value debt, with two broad measures – gross debt, representing all interest-bearing debt and lease debt, and net debt, which nets cash and marketable securities from gross debt. In 2024, here are the gross and net debt values for global companies, broken down by sector and sub-region: The problem with dollar debt is that absolute values can be difficult to compare across sectors and markets with very different values, I will look at scaled versions of debt, first to total capital (debt plus equity) and then then to rough measures of cash flows (EBITDA) and earnings (EBIT). The picture below lists the scaled versions of debt: Debt to Capital: The first measure of debt is as a proportion of total capital (debt plus equity), and it is this version that you use to compute the cost of capital. The ratio, though, can be very different when you use book values for debt and equity then when market values are used. The table below computes debt to capital ratios, in book and market terms, by sector and sub-region:  I would begin by separating the financial sector from the rest of the market, since debt to banks is raw material, not a source of capital. Breaking down the remaining sectors, real estate and utilities are the heaviest users of debt, and technology and health care the lightest. Across regions, and looking just at non-financial firms, the US has the highest debt ratio, in book value terms, but among the lowest in market value terms. Note that the divergence between book and market debt ratios in the last two columns varies widely across sectors and regions. Debt to EBITDA: Since debt payments are contractually set, looking at how much debt is due relative to measure of operating cash flow making sense, and that ratio of debt to EBITDA provides a measure of that capacity, with higher (lower) numbers indicating more (less) financial strain from debt. Interest coverage ratio: Interest expenses on debt are a portion of the contractual debt payments, but they represent the portion that is due on a periodic basis, and to measure that capacity, I look at how much a business generates as earnings before interest and taxes (operating income), relative to interest expenses. In the table below, I look at debt to EBITDA and interest coverage ratios, by region and sector:  The results in this table largely reaffirm our findings with the debt to capital ratio. Reda estate and utilities continue to look highly levered, and technology carries the least debt burden. Across regions, the debt burden in the US, stated as a multiple of EBITDA or looking at interest coverage ratios, puts it at or below the global averages, whereas China has the highest debt burden, relative to EBITDA. The Drivers and Consequences of Debt     As you look at differences in the use of debt across regions and sectors, it is worth examining how much of these differences can be explained by the core fundamentals that drive the debt choice – the tax benefits of debt and the bankruptcy cost.  The tax benefit of debt is the easier half of this equation, since it is directly affected by the marginal tax rate, with a higher marginal tax rate creating a greater tax benefit for debt, and a greater incentive to borrow more. Drawing on a database maintained by PWC that lists marginal tax rates by country, I create a heat map: The country with the biggest changes in corporate tax policy in the world, for much of the last decade, has been the United States, where the federal corporate tax rate, which at 35%, was one of the highest in the world prior to 2017, saw a drop to 21% in 2017, as part of the first Trump tax reform. With state and local taxes added on, the US, at the start of 2025, had a marginal corporate tax rate of 25%, almost perfectly in line with a global norm. The 2017 tax code, though, will sunset at the end of 2025, and corporate tax rates will revert to their old levels, but the Trump presidential win has not only increased the odds that the 2017 tax law changes will be extended for another decade, but opened up the possibility that corporate tax rates may decline further, at least for a subset of companies.         An interesting question, largely unanswered or answered incompletely, is whether the US tax code change in 2017 changed how much US companies borrowed, since the lowering of tax rates should have lowered the tax benefits of borrowing. In the table below, I look at dollar debt due at US companies every year from 2015 to 2024, and the debt to EBITDA multiples each year: As you can see, the tax reform act has had only a marginal effect on US corporate leverage, albeit in the right direction. While the dollar debt at US companies has continued to rise, even after marginal tax rates in the US declines, the scaled version of debt (debt to capital ratio and debt to EBITDA have both decreased). The most commonly used measure of default risk is corporate bond ratings, since ratings agencies respond (belatedly) to concerns about default risk by downgrading companies. The graph below, drawing on data from S&P< looks at the distribution of bond ratings, from S&P, of rated companies, across the globe, and in the table below, we look at the breakdown by sector:  The ratings are intended to measure the likelihood of default, and it is instructive to look at actual default rates over time. In the graph below, we look at default rates in 2024, in a historical context: S&P As you can see in the graph, default rates are low in most periods, but, not surprisingly, spike during recessions and crises. With only 145 corporate defaults, 2024 was a relatively quiet year, since that number was slightly lower than the 153 defaults in 2023, and the default rate dropped slightly (from 3.6% to3.5%) during the year.  The default spread is a price of risk in the bond market, and if you recall, I estimated the price of risk in equity markets, with an implied equity risk premium, in my second data update. To the extent that the price of risk in both the equity and debt markets are driven by the endless tussle between greed and fear, you would expect them to move together much of the time, and as you can see in the graph below, I look at the implied equity risk premium and the default spread on a Baa rated bond: Damodaran.com In 2024, the default spread for a Baa rated dropped from 1.61% to 1.42%, paralleling a similar drop in the implied equity risk premium from 4.60% to 4.33%.  Debt Design     There was a time when businesses did not have much choice, when it came to borrowing, and had to take whatever limited choices that banks offered. In the United States, corporate bond markets opened up choices for US companies, and in the last three decades, the rest of the world has started to get access to domestic bond markets. Since corporate bonds lend themselves better than bank loans to customization, it should come as no surprise now that many companies in the world have literally dozens of choices, in terms of maturity, coupon (fixed or floating), equity kickers (conversion options) and variants on what index the coupon payment is tied to. While these choices can be overwhelming for some companies, who then trust bankers to tell them what to do, the truth is that the first principles of debt design are simple. The best debt for a business is one that matches the assets it is being used to fund, with long term assets funded with long term debt, euro assets financed with euro debt, and with coupon payments tied to variables that also affect cash flows.  There is data on debt design, though not all companies are as forthcoming about how their debt is structured. In the table below, I look at broad breakdowns – conventional and lease debt, long term and short debt, by sector and sub-region again: The US leads the world in the use of lease debt and in corporate bonds, with higher percentages of total debt coming from those sources. However, floating rate debt is more widely used in emerging markets, where lenders, having been burned by high and volatile inflation, are more likely to tie lending rates to current conditions.     While making assessments of debt mismatch requires more company-level analysis, I would not be surprised if inertia (sticking with the same type of debt that you have always uses) and outsourcing (where companies let bankers pick) has left many companies with debt that does not match their assets. These companies then have to go to derivatives markets and hedge that mismatch with futures and options, creating more costs for themselves, but fees and benefits again for those who sell these hedging products. Bottom Line     When interest rates in the United States and Europe rose strongly in 2022, from decade-long lows, there were two big questions about debt that loomed. The first was whether companies would pull back from borrowing, with the higher rates, leading to a drop in aggregate debt. The other was whether there would be a surge in default rates, as companies struggled to generate enough income to cover their higher interest expenses. While it is still early, the data in 2023 and 2024 provide tentative answers to these questions, with the findings that there has not been a noticeable decrease in debt levels, at least in the aggregate, and that while the number of defaults has increased, default rates remain below the highs that you see during recessions and crises. The key test for companies will remain the economy, and the question of whether firms have over borrowed will be a  global economic slowdown or recession. YouTube Video Data Updates for 2025 Data Update 1 for 2025: The Draw (and Danger) of Data! Data Update 2 for 2025: The Party continued for US Equities Data Update 3 for 2025: The times they are a'changin'! Data Update 4 for 2025: Interest Rates, Inflation and Central Banks! Data Update 5 for 2025: It's a small world, after all! Data Update 6 for 2025: From Macro to Micro - The Hurdle Rate Question! Data Update 7 for 2025: The End Game in Business! Data Update 8 for 2025: Debt, Taxes and Default - An Unholy Trifecta! Data Links Debt fundamentals, by industry (US, Global, Emerging Markets, Europe, Japan, India & China) Debt details, by industry (US, Global, Emerging Markets, Europe, Japan, India & China)

While I was working on my last two data updates for 2025, I got sidetracked, as I am wont to do, by two events. The first was the response that I received to my last data update, where I looked at the profitability of businesses, and specifically at how a comparison of accounting returns on equity (capital) to costs of equity (capital) can yield a measure of excess returns. The second was a comment that I made on a LinkedIn post that had built on my implied equity premium approach to the Indian market but had run into a roadblock because of an assumption that, in an efficient market, the return on equity would equate to the cost of equity. I pointed to the flaw in the logic, but the comments thereafter suggested such deep confusion about what returns on equity or capital measure, and what comprises an efficient market, that I think it does make sense to go back to basics and see if some of the confusion can be cleared up. The Lead In: Business Formation     To keep this example as stripped of complexity as I can, at least to begin, I will start with two entrepreneurs who invest $60 million apiece to start new businesses, albeit with very different economics: The first entrepreneur starts business A, with a $60 million investment up front, and that business is expected to generate $15 million in net income every year in perpetuity. The second entrepreneur starts business B, again with a $60 million investment up front, and that investment is expected to generate $3 million every year in perpetuity. With these characteristics, the accounting balance sheets for these companies will be identical right after they start up, and the book value of equity will be $60 million in each company.  The return on equity is an entirely accounting concept, and it can be computed by dividing the net income of each of the two businesses by the book value of equity: Return on equity for Business A  = Net income for Business A / Book Value of Equity for Business A = 15/60 = 25% Return on equity for Business B  = Net income for  Business B / Book Value of Equity for Business B = 3/60 = 5% Assume that both these businesses have the same underlying business risk that translates into a cost of equity of 10%, giving the two businesses the following excess returns: Excess Return for Business A = Return on equity for Business A – Cost of equity for Business A = 25% -10% = 15% Excess Return for Business B = Return on equity for Business B – Cost of equity for Business B = 5% -10% = -5% In the language of my last post, the first business is a good one, because it creates value by earning more than your money would have earned elsewhere on an investment of equivalent risk, and the second is a bad one, because it does not.     The return on equity may be an equation that comes from accounting statements, but in keeping with my argument that every number needs a narrative, each of these numbers has a narrative, often left implicit, that should be made explicit. On business A, the story has to be one of strong barriers to entry that allow it to sustain its excess returns in perpetuity, and those could include anything from a superlative brand name to patent protection to exclusive access to a natural resource. In the absence of these competitive advantages, these excess returns would have faded very quickly over time. On business B, you have a challenge, since it does seem irrational that an entrepreneur would enter a bad business, and while that irrationality cannot be ruled out (perhaps the entrepreneur thinks that earning any profit makes for a good business), the reality is that outside events can wreak havoc on the bet paid plans of businesses. For instance, it is possible that the entrepreneur’s initial expectations were that he or she would earn much more than 5%, but a competitor launching a much better product or a regulatory change could have changed those expectations. In sum, the return on equity and its more expansive variant, the return on invested capital, measure what a company is making on the capital it has invested in business, and is a measure of business quality. The Market Launch     Assume now that the owners of both businesses (A and B) list their businesses in the market, disclosing what they expect to generate as net income in perpetuity. Investors in equity markets will now get a chance to price the two companies, and if markets are efficient, they will arrive at the following: Thus, a discerning (efficient) market would value business A, with $15 million in net income in perpetuity at $150 million, while valuing business B, with $3 million in net income in perpetuity, at $30 million. If you are wondering why you would discount net income, rather than cash flow, the unique features of these investments (constant net income, no growth and forever lives) makes net income equal to cash flow.     Even with this very simplistic example, there are useful implications. The first is that if markets are efficient, the price to book ratios will reflect the quality of these companies. In this example, for instance, business A, with a market value of equity of $150 million and a book value of equity of $60 million, will trade at 2.50 times book value, whereas company B with a market value of equity of $30 million and a book value of equity of $60 million will trade at half of book value. Both companies would be fairly valued, though the first trades at well above book value and the second at well below, thus explaining why a lazy variant of value investing, built almost entirely on buying stocks that trade at low price to book ratio,, will lead you to holding bad businesses, not undervalued ones.     As I noted at the start of this post, it was motivated by trying to clear up a fundamental misunderstanding of what return on equity measures. In fact, the working definition that some commenters used for return on equity was obtained by dividing the net income by the market value of equity. That is not return on equity, but an earnings to price ratio, i.e., the earnings yield, and in these examples, with no growth and perpetual (constant) net income, that earnings yield will be equal to the cost of equity in an efficient market. Extending the Discussion     One of the advantages of this very simple illustration is that it now can be used as a launching pad for casting light on some of the most interesting questions in investing: Good companies versus Good Investments: I have written about the contrast between a good company and a good investment, and this example provides an easy way to illustrate the difference. Looking at companies A and B, there is absolutely no debating the fact that company A is better company, with sustainable moats and high returns on equity (25%), than company B, which struggles to make money (return on equity of 5%), and clearly is in a bad business. However, which of these two companies is the better investment rests entirely on how the market prices them: As you can see, the good company (A) can be a good, bad or neutral investment, depending on whether its is priced at less than, greater than or equal to its fair value ($150 million) and the same can be said about the bad company (B), with the price relative to its fair value ($30 million). At fair value, both become neutral investments, generating returns to shareholders that match their cost of equity. The Weakest Link in Excess Returns: The excess return is computed as the difference between return on equity and the cost of equity, and while it is true that different risk and return models and differences in risk parameters (relative risk measures and equity risk premiums) can cause variations in cost of equity calculations, the return on equity is the weaker link in this comparison. To understand some of the ways the return on equity can be skewed, consider the following variants on the simple example in this case: Accounting inconsistencies: As an entirely accounting number, the return on equity is exposed to accounting inconsistencies and miscategorization. To illustrate with our simple example, assume that half the money invested in business A is in R&D, which accountants expense, instead of capitalizing. That business will report a loss of $15 million (with the R&D expense of $30 million more than wiping out the profit of $15 million) in the first year on book capital of $30 million (the portion of the capital invested that is not R&D), but in the years following, it will report a return on capital of 50.00% (since net income will revert back to $15 million, and equity will stay at $30 million). Carrying this through to the real world, you should not be surprised to see technology and pharmaceutical companies, the two biggest spenders on R&D, report much higher accounting returns than they are actually earning on their investments.. Aging assets: In our example, we looked at firms an instant after the upfront investment was made, when the book value of investment measures what was paid for the assets acquired. As assets age, two tensions appear that can throw off book value, the first being inflation, which if not adjusted for, will result in the book value being understated, and accounting returns overstated. The other is accounting depreciation, which often has little to do with economic depreciation (value lost from aging), and subject to gaming. Extrapolating, projects and companies with older assets will tend to have overstated accounting returns, as inflation and depreciation lay waste to book values. In fact, with an aging company, and adding in stock buybacks, the book value of equity can become negative (and is negative for about 10% of the companies in my company data sample). Fair Value Accounting: For the last few decades, the notion of fair value accounting has been a fever dream for accounting rule writers, and those rules, albeit in patchwork form, have found their way into corporate balance sheets. In my view, fair value accounting is pointless, and I can use my simple example to illustrate why. If you marked the assets of both company A and company B to market, you would end with book values of $150 million and $30 million for the two companies and returns on equity of 10% for both firms. In short, if fair value accounting does what it is supposed to do, every firm in the market will earn a return on equity (capital) equal to the cost of equity (capital), rendering it useless as a metric for separating good and bad businesses. If fair value accounting fails at what it is supposed to do, which is the more likely scenario, you will end up with book values of equity that measure neither original capital invested nor current market value, and returns on equity and capital that become noise. Growth enters the equation: For companies A and B, in this example, we assumed that the net income was constant, i.e., there is no growth. Introducing growth into the equation changes none of the conclusions that we have drawn so far, but it makes reading both the return on equity and the earnings yield much messier. To see why, assume that company A in the example continues to have no growth, but company B expects to see compounded annual growth of 50% a year in its net income of $3 million for the next decade. We can no longer consign company B to the bad business pile as easily, and the current earnings to price ratio for that company will no longer be equal to the cost of equity, even if markets are efficient. Incorporating growth into the analysis will also mean that net income is not equal to cash flow, since some or a large portion of that net income will have to get reinvested back to deliver the growth. In fact, this is the argument that I used in my second data update to explain why comparing the earnings yield to the treasury bond rate is unlikely to yield a complete assessment of whether stocks are under or over valued, since it ignores growth and reinvestment entirely. Exiting bad businesses: This example also helps to bring home why it is so difficult for companies in bad businesses to fix their "badness" or exit their businesses. In the case of company B, for instance, telling the manager to find projects that earn more than 10% is advice that can be freely dished out, but how exactly do you invent good projects in a business that has turned bad? While exiting the business seems to be a better choice, that presupposes that you will get your capital ($60 million) back when you do, but in the real world, potential buyers will discount that value. In fact, if you divest or sell the bad business for less than $30 million, you are actually worse off than staying in the business and continuing to generate $3 million a year in perpetuity, which has a $30 million value. In the real world, most companies in bad businesses hire new CEOs, restructure their businesses and enter new businesses in a desperate attempt to become good businesses, and enrich consultants and bankers, but not their own shareholders, along the way. Conclusion     Many of the comments on my seventh data update, and on my explanation about why  ROE and cost of equity don’t have to be equal in an efficient market, came from people with degrees and certifications in finance, and quite a few of the commenters had “finance professional” listed in their profile. Rather than take issue with them, I would argue that this misunderstanding of basics is a damning indictment of how these concepts and topics are taught in the classroom, and since I may very well be one of the culprits, one reason that I wrote this post is to remind myself that I have to revisit the basics, before making ambitious leaps into corporate financial analysis and valuation. For those of you who are not finance professionals, but rely on them for advice, I hope this is a cautionary note on taking these professionals (consultants, appraisers, bankers) at their word. Some of them throw buzzwords and metrics around, with little understanding of what they mean and how they are related, and it is caveat emptor. YouTube Video