Please find our summary of a fantastic lecture conducted for MDI students on interpreting Cyclical businesses valuations.
Tobin’s Q: It is a ratio applicable to companies which are quite capital intensive with low entry barriers (Mostly manufacturing businesses). Ratio: Market value of the firm/Replacement costs.
If Market value of the firm is more than the replacement cost then the ratio will be more than 1 and vice versa.
He takes the example of shipping companies. Shipping companies were making a whole lot of money because during that time the demand of ships was high and supply was less. Also the size of ports was quite less to accommodate a whole lot of ships. The freight charges were quite high.
Due to this tailwind in the sector as a whole, every company whether having a weak balance sheet or a strong balance sheet were minting money. Because of the tailwind the earnings went through the roof and as the market loves earnings it extrapolated the earnings way into the future and because of that valuations took a very high and unrealistic turn.
So if I take the enterprise value of the firm which is the total asset value (Including financial assets) –liabilities; it was valued very high by the market. It happens because normally shipping industry has a very high gestation period and the supply of the ship will remain a little less in the coming period so the markets extrapolate the earnings way into the future.
Now if the Tobin’s Q hits 6 it means that for every replacement cost of around 100 million dollars the market value is around 600 million dollars which is insane, so the markets can give such valuations because it is not rational all the time.
He talks about what goes into the mind of an entrepreneur when such a situation arises where everything is positive; he says with the positive situation arises greed because now you have the delusion that positive things will last and you will start ordering the companies which manufacture ships and not only you the competitors will also order which will create a capital expenditure boom.
Bankers will also come and support you because they also have some incentive and they will influence you to borrow more to make more Capex because they see nothing wrong happening anytime soon.
Another root cause of failure is envy. All the companies in the shipping industry become envious of each other if anyone of them is placing large number of orders and growing like crazily.
The seeds of disaster are already sown when decisions come under the emotional influence of envy and greed. Whenever the economic crises strikes there will be over supply of ships and with no takers in that situation the companies which have a bad balance sheet will struggle or even may go bankrupt.
Bakshi sir talks about how after the Tobin’s Q hit 6 it slowly turns downward because of the economic turmoil and he has seen the Tobin’s Q fall down to 0.2. In the situation that the replacement cost is more than the market value the new players won’t really expand and which will lead to industry consolidation.
In industry consolidation the weaker players will be approached by the banks because they defaulted and order to pay them they will have to sell most of its assets to the company which have a strong balance-sheet. So what happens is the strong players will get the access to assets in dirt cheap prices and when the cycle reverts the margins will again turn back to normal because of price increase and the huge amount of capacity already there with the company.
Another concept that he talks about is Mean reversion in which the cycle always comes back to the normal and if we understand this phenomenon it will be easy for us to avoid mistakes.
Replacement costs: It is a concept which relates to how much it would cost to basically replace all the assets today.