Growing Intrinsic Value in the New Normal
April '10
Last year, Bill Gross of Pimco coined the phrase “new normal” to describe what economic life might be like as the global economy recovers from one of the worst economic storms since the 1930s. While there is considerable uncertainty around what the new normal will look like, it is likely to be a world where:
- Profitability is lower across almost all markets – margins have come down significantly and are unlikely to recover fully for quite a while, the amount of capital per dollar of revenue has risen as revenue has fallen, and nearly all companies are reducing financial leverage. As a result, the sustainable return on equity for the economy as a whole has declined from its pre-recession norm in the mid-teens and is now expected to be in the low-teens post-recovery.
- Growth is returning at a slower pace than in past recoveries – the recession caused a steep decline in global demand, and the climb back out looks like it will take longer as corporate and household balance sheets rebuild slowly and unemployment remains high. In addition, there has been a “reset” in consumers’ willingness to pay (referred to as the age of frugality) that has caused major shifts in demand across markets; and
- Risk is fundamentally higher – both the level of volatility has increased (it skyrocketed during the meltdown and has since settled into a range 20-30% higher than before) and the price of risk has increased (the cost of equity capital is now near 10% vs. 8% pre-recession). This has caused the expected spread between ROE and the cost of equity to fall sharply into negative territory, even worse than the dot-com bust in the early 2000s.
Since the intrinsic value of a company is driven by profitability, growth and risk, growing intrinsic value will face significant headwinds. These headwinds can be overcome if management focuses on value in a different way and adopts new practices that drive changes in the firm’s management model, strategy choices and operating practices.