It's the weekend!

Grab a cup of coffee. In this thread, I will explain:

1. What is cost of capital and WACC?
2. How does a company's capital structure impact its valuations?
3. How to code WACC as a field in screener?

Let's dive right in.

Before we start to explore cost of capital, we first need to understand what is meant by capital structure of a company.

Any business at a very simplified level, works in three steps

Step 1: Raise funds from various types of investors
Step 2: Use those funds to build projects that generate higher returns
Step 3: Deliver excess returns back to investors

In Step 1, when a business is raising funds from investors, it has a few options.

It can either raise funds from private sources (aka Private Equity and Venture Capital)
or
It can raise funds from public investors (aka IPO)
or
It can borrow funds from a bank (aka debt)

Each of these type of investors (Private Equity, Venture Capital, Public Investors, Debt) have a very different risk profile and as such demand different levels of return.

A business also has several financial instruments at its disposal for raising funds.

These include selling equity through preference shares, ordinary equity shares, convertible bonds, or plain debt.

Once a business has finished raising funds, they are recorded on the left side of the Balance Sheet, also known as "Liabilities" or "Sources of Funds".

The right side of the Balance Sheet, or "Assets", represents the application of these funds.

The mix (debt vs preference shares vs equity shares vs convertible bonds vs anything else) in which a business raises funds is known as its capital structure.

The cost of capital is simply the average rate of return a business has to generate in order to pay for these sources of funds (or capital).

Cost of capital has a direct relation to what kind of projects a company can undertake in order to generate return for its investors.

A good capital allocation is where a company invests in those projects that have the ability to generate rate of return higher than cost of capital for the company.

A high cost of capital will force a company to undertake only those projects that generate very high rates of return (an unrealistic target).

Where as, if a company has low cost of capital, it becomes easier to undertake and consider a wide variety of projects.

For example, if the cost of capital for the company is 18%, it can only invest in those projects that have the ability to generate a return of 19% or higher - a tough task to achieve.

A good business is one that can easily generate a return on its assets much higher than the cost of its capital (aka good capital allocation).

Good companies devote considerable attention to their capital structure, aiming to optimize their cost of capital.

Consider Apple as an example – it is renowned for having one of the most efficient capital structures in the tech industry.

At the bottom of the interest rate cycle (in last 10 years) Apple raised the maximum amount of debt at rates as low as 1.35%

At the same time, Apple embarked upon a major share re-purchase program, there by reducing the number of issued shares and effectively reducing its overall cost of capital (cost of equity is always much higher than cost of debt).

Now that we understand what is meant by Capital Structure and Cost of Capital, lets explore how to calculate cost of capital and use it in our investing process.

A major method used to calculate cost of capital is known as Weighted Average Cost of Capital or WACC.

This is its formula (dont be frightened - its pretty simple once we understand the logic behind it).

Weighted Average Cost of Capital, as the name suggests, is the weighted average of the cost of various sources of capital in a business.

This is what the parts of the formula means

wd = weight of debt
rd = cost of debt
1-t = adjust for tax rate
wp = weight of preference shares
rp = cost of preference shares
we = weight of equity shares
re = cost of equity

Each of these components like cost of debt and cost of equity have various methods to calculate which we will explore in some other thread at another time.

So how does a company's capital structure impact its valuations?

A company with a low cost of capital (efficient capital structure) and a higher return on assets is given a higher valuation multiple by investors

as that business has proven ability to allocate money efficiently.

Similarly, a company that is unable to generate return on its assets higher than its cost of capital is essentially eroding shareholder and investor wealth by poor allocation of capital - there by getting a lower valuation multiple.

Interest rates also have a large role to play in cost of capital.

To help explain this concept with a simple example

Apple can no longer issue debt at 2% interest rates for 10 years when the yield of a US 10 year bond (risk free) is 3.6%.

So, for Apple to raise more debt, it needs to pay a higher interest rate than US Fed, there by increasing its cost of capital.

Finally lets explore, how can you leverage the concept of WACC to screen for companies that are good capital allocators.

On screener.in create a custom field & input the below formula

This is a crude way of calculating WACC, here we have assumed the cost of equity to be 15% (can be lower or higher for individual companies) & cost of debt as 10% (can be lower or higher in practice)

This method of calculating WACC is close enough and can help us in screening companies that are able to generate return on assets higher than their cost of capital.

Once the custom WACC field is created, on the screening page you can simply screen for companies where WACC is lower than 3 or 5 year average of Return on Assets


I hope this thread, helped you understand the concept of cost of capital, WACC and how it can be leveraged to screen companies.

If you're new here, I write a new thread every weekend, explaining an investing concept.



Here is a link to all my other threads

https://twitter.com/itsTarH/status/1401095938945425410?s=20


Occasionally conduct value chain webinars for various industries, here is one for #RenewableEnergy sector 👇


https://twitter.com/i/status/1663883243060629504

Also, publish deep dives into one Indian listed company every month. Join 18,000+ readers at blog.investkaroindia.in

You can read the unrolled version of this thread here: https://typefully.com/itsTarH/msyD2oh

Understanding Cost of Capital and WACC

It's the weekend!
Grab a cup of coffee, in this thread I will explain

1. What are ETFs?
2. How are they different from Mutual Funds?
3. What are factors to consider while investing in ETFs?

Lets dive right in.

ETFs stand for Exchange Traded Funds

The easiest way to understand them is to think of them as Mutual Funds that are traded on the exchange just like stocks.

(technically, ETFs are nothing like Mutual Funds)

ETFs are structured as pools of investment that are inclined to

a. lower the fees associated with investment
b. shift the bulk load of fees to frequent traders of the ETF than holders
c. allow investors to invest in diverse set of securities / asset classes easily


ETFs originated after the stock market crash of 1987 in US

'Passive Investing' was the new shiny thing and investors wanted a low cost way to invest in the index without any manager actively managing their investments

Enter Nate Most

Nate Most is known as the father of ETFs
A physicist by training, Nate got the idea of ETF from warehouse receipts

Once a commodity is stored in a warehouse, the depositor gets a warehouse receipt

They could then use the warehouse receipt to buy, sell, loan, finance etc. without moving the commodity from the warehouse each time.


An ETF works on the same principle

When you buy an ETF, what you are indeed buying is an ownership receipt to shares deposited at a depository somewhere in the world

Similarly, when you sell the ETF, you are selling the ownership receipt instead of the underlying shares

Because each time, the buy or sell occurs, the shares do not have to be transferred out of the depository, you tend to save on a lot of expenses

This is one of the main reasons why expense ratios on ETF are so low

If you want to learn more about History of ETFs, you can listen to this short podcast by Bloomberg

https://open.spotify.com/show/0j03M8cOnnsI1nNfOTqPya

The way an ETF functions is also different from Mutual Funds

Typically, each ETF has an sponsor

It is the sponsors responsibility to decide what shares/securities go into the ETF in what proportions and what gets out

For example, Cathie Wood and ARKK Management is the sponsor of ARKK Innovation ETF

Below the sponsor are Authorized Participants (APs)

These APs are usually broker dealers who are the only authorized market participant to create or redeem units of an ETF

APs make their return via the bid and ask spread on the ETF & are the main providers of liquidity

This de-linkage between the ETF Sponsor and Authorized Participant is one of the reasons ETFs do not ever have a redemption problem

Authorized Participants take care of the creation, redemption and occasional rebalancing process

Lets understand this in detail.

ETF Creation Process

Whenever new units of ETF need to be created, the AP will simply buy the underlying stocks from market in proportions described by the ETF sponsor

AP then delivers this basket of stocks in exchange for ETF units

These units are then sold in the market

ETF Redemption Process

Whenever AP wants to redeem units of ETF, they will sell the units to ETF sponsor and get the basket of underlying securities

Regular buying and selling of ETF units for cash happens in the secondary market on the exchange & in no way effects the sponsor

Finally, lets understand what are some of the factors to pay attention to while investing in an ETF

The first one is your reason to invest

ETFs are great for passive index investing since bulk of the cost burden is transferred to traders of the ETF than holders

However, in India, index ETFs arent popular & majority still invest via Mutual Funds

This lead to liquidity issues

Similarly, residing in India, its better to invest into foreign indexes like Nasdaq 100, S&P 500 etc. via a domestic mutual fund instead directly into an overseas index ETF

as taxation of the ETF returns will bite away a significant chunk of your overall returns

ETFs are a great way to diversify your portfolio and get exposure to certain industries without the hassle of taking stock specific risks

For example, you may buy an ETF like $UFO which invests in a variety of Space Sector companies

ETFs are also a great way to take geographic exposure without going through all the trouble of setting up brokerage accounts in the local jurisdiction to own the stock

For example, $REMX is an ETF that invests in rare earth companies around the world from Australia to China

Below are some of the checks you should perform, before investing into an ETF

Check # 1
What is the tracking error?

Tracking error refers to the standard deviation of differences in daily performance between the index and fund tracking the index

Tracking errors are usually reported & tracked for a 12 month period

Larger the tracking error, lower the return

Check # 2

How often the sponsor churns the ETF?

Cathie Wood for example is famous for churning the holding of the ETF on an almost daily basis

Higher churn rates indicate uncertainty by the sponsor of the underlying holdings

If you cant be certain of the underlying holdings, what good is the ETF?

Check # 3

Is the taxation rules for investing in ETF in your area favorable?

I see a lot of new app based brokerage houses advocating for in US based ETFs without informing their customers about the taxation rules

Check if tax rate is eating your return?

Check # 4

Is the ETF liquid & fund house reliable?

Liquidity shouldn't be a concern if you are investing for greater than one year but if an ETF is too small in size, that liquidity may never arrive.

Finally, Vanguard & iShares command more confidence over a random fund house

Before closing this thread,

below are screenshots of my handwritten notes of the ETF chapter in the CFA Curriculum (in case you want to go further down the ETF rabbit hole)


I write a new thread every weekend simplifying investing concepts.
 

All my previous work, can be found here
https://twitter.com/itsTarH/status/1401095938945425410?s=20&t=TWzR90JI8SGi0oSpirNkhA

I also write occasional deep dives and long form articles on stocks and emerging investing trends, you can subscribe to them for free here

https://www.getrevue.co/profile/itstarh

Occasionally, conduct webinars that deep dive into a sector in its true sense



Here is a 5 hour long webinar on Green and Renewable Energy ☀️


Lots of India, Chinese and US companies covered along with Global Demand and Supply scenario

https://research.investkaroindia.in/s/store/courses/description/RenewableWebinar

Thank you for reading, here is another thread, you may like

https://twitter.com/itsTarH/status/1510184486406799361?s=20&t=TWzR90JI8SGi0oSpirNkhA


You can read the unrolled version of this thread here: https://typefully.com/itsTarH/YvckzbB3hfcO

ETFs, Explained

It's the weekend!



Grab a cup of coffee, in this thread I will explain



1. What is a Yield Curve? 
2. Why is it an important indicator of Recession? 
3. Is an Economic Recession around the corner?
 

Lets dive right in!

Before we understand a Yield Curve, lets get some of the basic terminology out of the way

1. What is a Bond?

A bond is a fixed income financial instrument which represents a loan made by an investor to a borrower

The investor typically receives payment in the form of interest and a lumpsum (principal) on maturity

The interest rate on a bond is known as coupon rate.

There are many types of bonds like

1. Zero Coupon : Pays both interest and principal at maturity
2. Sovereign Bonds : Issued by a Government or a Quasi Government Institution
3. Corporate Bonds : Issued by corporate like banks, established companies etc.

Coupon (Interest Rates) on a bond are decided based on the issuer's credit rating

The higher the credit worthiness of the issuer, the lower the coupon rate

Credit Rating on a Bond is usually assigned by credit rating agencies like Moody's or Standard & Poor's (S&P)

US Treasury Bonds are always assigned a rating of AAA (Triple A) as they are backed by the Government and are considered default free

Anything with a credit rating of BBB (Triple B) or lower is considered as 'junk bond' or a 'high yield bond' as they have high risk of default

2. What is Yield?

Yield is simply the return an investor of a bond realizes over the course of the bond holding period

Formula for calculation of a Bond Yield

Bond Yield = Interest Payments / Bond Price

Since, coupon (interest) payments on a bond along with tenure of a bond is fixed

your yield on a bond simply depends on the change in its price

Let me explain this concept with an example of a Dividend Yield (easier to relate to)

The logic and concept followed for calculation and estimating a Dividend Yield can be directly applied to a bond yield as well.

Take for example, Dividend Yield calculation of ITC

ITC as per its policy issues out 85% of its profits as Dividends to its Shareholders, this comes to around ~Rs 10/share

When ITC was trading 
at 180/share, the Div. Yield was 5.5%
at 254/share, Div. Yield is  3.93%

In the above calculation, the dividend didn't change but because the price in denominator of our formula changed, it led to a change in Dividend Yield

If Bond Prices go up, the Yield on the bond will decrease
If Bond Price come down, the Yield on the bond will increase

Just like stock prices, bond prices keep on changing depending on economy, Central Bank interest rates, demand + supply etc.

3. What is a Yield to Maturity?

Suppose if you buy a 10 year Govt Bond that pays 5% interest yearly for Rs 1000

If instead of selling the bond when bond price rises to Rs 1100, you held on to your bond until its maturity date till end of 10 years

The present value of all the coupon (interest) payments that you will receive on the bond along with the principal repayment at the end of 10 years, is called Yield to Maturity.

You can learn more about the concept of present value at the below link https://www.investopedia.com/terms/p/presentvalue.asp

4. What is Yield Curve?

A Yield Curve is just a graphical representation of Yields of various bonds with similar credit rating but differing maturities

When the media talks about a Yield Curve, they are primarily talking about the US Treasury Yield Curve

which depicts the Bond Yields on US Treasury Bonds for varying maturity dates ranging from 1 Month to 30 Years

So now that you have understood the basics, lets try and answer a burning question

Why is Yield Curve used to predict a Recession?

Yield Curve are typically of three types:

a. Upwards Sloping (Most of the Time)
b. Flat (Rare)
c. Inverted Yield Curve (Very Rare)


The shape of the Yield Curve is dependent on a simple logic

Yields on longer term bonds should be much higher compared to Yields on shorter term bonds

as

with longer term bonds you are taking more risk and hence need more interest as return

As such in a normal economic environment, we have upwards sloping Yield Curves like shown below

Inverted Yield Curves happen when yields on short term bonds rise above Yields on Long Term Bonds

implying that near term risk in the economy is higher compared to long term

Because near term economy is considered risky

Bond Investors start dumping their short term bonds in favour for longer duration bonds

As such

Demand for Short Term Bonds decreases, causing Bond Prices to collapse and Yields to Increase

While

Demand for Longer Term Bonds Increases, causing Bond Prices to rise and Yields to Decrease

Thus, creating the inverted Yield Curve.

Inverted Yield Curves are an excellent tool to predict upcoming Recessions as per US Federal Reserve

Here are some of their publications on this subject

https://www.frbsf.org/wp-content/uploads/sites/4/el2018-07.pdf

https://fredblog.stlouisfed.org/2018/10/the-data-behind-the-fear-of-yield-curve-inversions/

https://www.chicagofed.org/publications/chicago-fed-letter/2018/404


An Inverted Yield Curve has successfully predicted every recession since 1957

It even inverted right before the pandemic!

Typically an economic recession follows after 7 to 24 months since the Yield Curve Inversion

Most recently the US Treasury 2 and 10 yr Yield Curve Inverted on 29th March 2022

imply the onset of a recession anytime between end of 2022 to 2024.

This brings me to the last Question of this thread

IS AN ECONOMIC RECSSION AROUND THE CORNER?

All Economies, work on a Peak to Trough cycle and as much as Expansions are part of the Economic Cycle, so are Recessions

Without Recessions, we wouldn't have the opportunity to reset and economy would overheat and turn into a bubble which when popped could bring depression.

For a Recession to happen, you need several ingredients

1. Slowing Economic Growth
2. High Unemployment Rate
3. High to Medium Fed Interest Rates

None of the characteristics today satisfy the onset of a Recession

For example,

US last week reported the lowest joblessness since 1969!

And Fed Interest Rates are at the bottom they have ever been with the only option for Fed to Increase them and not decrease them as they would to prevent a recession

Inflation is rampant throughout the world today but that inflation is not caused by lack or overdemand in the economy (as it would during a peak of an economic cycle)

The inflation today is purely a result of supply side shortages cause by the onset of the pandemic

Considering all of the above, will we face a recession as predicted by the Yield Curve?

I don't know and I am not sure if anybody does.

I write a new thread every weekend simplifying investing concepts. 

All my previous work, can be found here

https://twitter.com/itsTarH/status/1401095938945425410?s=20&t=TE54StiBZNg7cy6719IPGg

Occasionally, conduct webinars that deep dive into a sector in its true sense



Here is a 5 hour long webinar on Green and Renewable Energy ☀️

Lots of India, Chinese and US companies covered along with Global Demand and Supply scenario

https://research.investkaroindia.in/s/store/courses/description/RenewableWebinar

Thank you for reading, see you in the next thread 🧵

You can read the unrolled version of this thread here: https://typefully.com/itsTarH/8D7Mdyv


Understanding Cost of Capital and WACC

ETFs, Explained

Yield Curve & Recession