evaluating management: Donald Trump and real estate

Last year Forbes published an analysis by James Elkins, a professor in the finance department at the University of Texas, that concludes Mr. Trump has underperformed the average real estate professional in the US by a whopping 57% over his career, despite the boost to returns he achieved by maintaining almost twice the average amount of financial leverage.

The results are highly tentative.  Prof. Elkins uses a REIT index as a proxy for overall real estate returns.  He also employs Mr. Trump’s statement of his starting net worth and the Forbes $4.5 billion estimate of his 2016 wealth (the 2017 estimate is $1 billion lower).

On the industry benchmark, my experience with real estate moguls, mostly outside the US, is that the returns on their private real estate investments are generally higher than those they achieve in their publicly traded vehicles.  In Mr. Trump’s case, his net worth includes his considerable earnings as a reality show star, as well as the potentially positive effect of debt forgiveness through bankruptcies.

In short, the 14.4% annual return on equity Elkins uses for the industry is probably too low and the 12.5% return he figures for Trump is too high.

My question is what the returns on capital are in the Elkins example.

According to Elkins, REITs have an average debt to equity ratio of about 30%.  This means they have a mix of roughly three parts equity, one part debt.  Assume that their average cost of debt has been 8%–a figure that seems reasonable to me but which I’ve just plucked out of the air.  If so, their 14.4% return breaks out into roughly a 13% return on capital (actually operating real estate ventures) and 1.5% from using financial leverage.

This calculation implies that Mr. Trump’s 12.5% return breaks out to something like 9.5% from real estate and 3% from financial leverage.

At first glance, the difference between a 14.4% annual return and a 12.5% return doesn’t seem like much.  Prof. Elkins’ point is that over a career being a relative laggard adds up.   In this case, it translates into having $4.5 billion instead of $23 billion.  Mine is the numbers flatter Mr. Trump’s planning and management skills, which fall more deeply below the average in the real estate industry than his overall results.



evaluating management: issues with financial leverage

Given the possibility to boost return on equity substantially, why is it that every publicly traded corporation doesn’t make extensive use of financial leverage?

Several reasons:

–as I mentioned in my initial post, in some areas of the world investors think using debt capital is a bad thing, either because they believe debt is unethical or (incorrectly, in my American view) that debt is more expensive than equity

Philosophy aside, having debt on the balance sheet has risks:

–debt service (interest and principal repayments) is an immediate subtraction from operating cash flow.  If a company takes on excessive debt, if it makes a mistake in capital deployment, or if it is particularly sensitive to the ups and downs of the business cycle, debt service can become a burden.  In extreme cases, debt holders may have the right to accelerate the repayment schedule, restrict company operations–or even take over management of the firm through bankruptcy proceedings

–having a large amount of debt can hamper a firm’s ability to respond to a changing competitive environment.  Macy’s failure to build an effective online retail presence, for instance, has been attributed to its need to devote large amounts of operating cash flow to debt service.

In addition, Wall Street investors tend to believe (correctly, I think) that it doesn’t take much skill to float a bond issue or get a bank loan.  It’s much harder to employ capital well in running operations.  So while investors may want the extra returns that a leveraged company can achieve, they will pay a much higher price for returns on capital than for returns on leverage.

evaluating management: return on capital

equity capital

Yesterday, I wrote about return on equity, as it applies to a company that uses only this form of capital, i.e., has no long-term borrowings, no financial leverage.

debt capital

In most places, companies are allowed to employ debt capital in their long-term operating plans as well as equity.

Opinions differ as to whether this is a good idea or not.  Americans tend to approve, on the idea that debt is a cheaper form of capital than equity; investors in the UK and Europe tend to disapprove–arguing that debt is a more expensive form of capital than equity.  In the Islamic world straight debt is not allowed.

My chief comment is old saw that “leverage works both ways;”  that is, during an economic expansion it’s most often a return booster, while in bad times it can be an albatross around the firm’s neck.


Let’s say a company goes public by selling 1000 shares at $10 each.

Once it’s public, it issues $10,000 worth of ten-year bonds with a 5% coupon.

Now it has $10,000 in equity and $10,000 in debt.

Let’s say it invests all the money in projects that produce a $2000 annual return. (For simplicity’s sake, let’s make the (unrealistic) assumption that the money is all raised and invested in projects that are instantly up and running on January 1st).  Let’s also ignore taxes.)

At the end of year 1, the firm has earned $2000.

return on capital

Its return on capital is:  $2000 ÷ ($10,000 debt + $10,000 equity = $20,000), or 10%.

return on equity

Its return on equity is:  ($2000 – $500 in interest = $1500) ÷ $10,000 equity  = 15%.

return on leverage

Let’s define another term, return on leverage, as the return on equity minus the return on capital.  In this case, the return (to equityholders) on (or from) leverage is +5%.

Why do so?   Why in the form of a simple subtraction?

As to the form, the sole reason is because it is a simple thing to figure out.

I think it’s important to break down the returns a management is producing for shareholders into two components to quqntify how good it is at two different management skills–how company operations are being run (return on capital) and how those returns are being supplemented by shrewd use of debt financing (return on leverage).

I say “supplemented” because in a well-managed business the lion’s share of the returns will come from operations.  Returns from leverage will be the icing on the cake.

Looked at in a different way, what conclusion should we draw if most of the returns come from leverage?  One worry is that the firm’s management doesn’t have the necessary operating skills to be successful and is substituting aggressive risk taking with company financing to cover up for this deficiency.

For example:

Suppose the company described above earns $1200 in year 1.

That’s a 6% return on capital.

The return on equity is ($1200 – $500) ÷ $10,000 = 7%.

The return on leverage = 1%!  This is trouble, because the company is barely covering the cost of its borrowing.

A worse case:

The company earns $400.

The return on capital is 2.5%.

The return on equity is ($400 -$500) ÷ $10,000 = -1%

The return on leverage is -1% -2.5% = -3.5%.  This is a disaster.


More tomorrow.



evaluating management: returns

One of the most straightforward ways of evaluating how a company management is doing is by looking at the returns it achieves on the money it invests on behalf of shareholders.  Like most things in finance, this starts out as a very simple task, but soon enough adds refinements that make the evaluation process look a lot more complex than it actually is.

We’ll start with return on equity.

initial equity

A new company forms and sells 1000 shares to investors at $10 each, for a total of $10,000.  It invests all of that money one January 1 of its first year.

During that year it earns $1000 in net income.

Its return on equity for year 1 is 10% ($1000/$10,000).  At this point it has no long-term debt, so its return on capital (capital = equity plus long-term debt) is also 10%.

equity grows

If the company pays no dividends, it now has $11,000 in equity (capital, too) at the beginning of year 2.  To maintain a 10% return on equity (and capital) it must earn $1,100 in year 2.

book value

The total amount of equity a company has to invest is also called “book value,” because it’s the value of the equity entry on the company’s financial records (books).

All other factors being equal, a company whose management achieves a high return on equity tends to trade at a premium to book value.  One that continually produces sub-par returns tends to trade at a discount.  The financial sector in particular, because it’s hard to figure out the tons of transactions that the big firms routinely execute, tends to trade on price to book.


Tomorrow, adding debt to the picture.

new CEO for Tiffany (TIF)

TIF has languished for a number of years, for several reasons:

–the waning of the important Japanese market

–the shift of Chinese jewelry buyers away from foreign firms and toward local creations

–the recession, which lowered spending on jewelry worldwide

–perhaps most important, a lack of success in providing new designs for regular customers.

The company’s greatest strength is its brand name.  It’s unique in being able simultaneously to appeal to ultra-wealthy customers spending $10,000+ a pop and to ordinary people looking for a $200 trinket to have wrapped in the iconic blue box.

Oddly, in the discussion of TIF’s merchandising as being “tired” that I’ve been reading, analysts and (especially) reporters have been referring to this ability to serve low-end customers while still retaining the aura of exclusiveness that attracts the wealthy as a weakness.  Hard to understand.

At the same time, what’s being missed is the hole that has long existed in the TIF merchandise lineup–items that appeal to customers wanting to spend $2,000-$10,000. This middle ground is dominated by firms like Bulgari, which coincidentally have little presence among TIF’s customers in either of its market segments.

That’s wha’s so intriguing about the appointment of Allessendro Bogliolo, a former Bulgari executive, as TIF’s new CEO–something no one’s mentioning.

the Saudi Aramco ipo

A while ago Saudi Arabia decided to list its government-owned oil and gas company, Aramco, both on its own national stock exchange as well on at least one foreign bourse.  The potential listing date is thought to be some time next year.  The Saudis are rumored to be thinking of selling 5% of the company for $100 billion–implying a $2 trillion valuation for the company as a whole.

Why the long delay?

It’s to whip a government bureaucracy into palatable enough shape for foreign investors, as well as local citizens, to want to buy shares.  It’s also to find a foreign stock exchange big enough, and willing enough, to act as host.  “Willing,” in this case, means among other considerations, being able to accept the corporate opacity that the Saudi government would surely like to surround the operations of its national treasure.

While world interest centers on trying to figure out what stock exchange is the most eager to compromise its governing principles in order to achieve a huge payday for its domestic brokerage firms (my answer:  all of them), I don’t think this is the most interesting question.

My query is why the offering.  I see two possibilities:

–the Saudi government hopes to achieve greater efficiency of operations by opening Aramco management to the scrutiny of the investing public

–the Saudi government wants/needs the $100 billion proceeds to fund its government spending.

I’m sure the reality is that both are key objectives.  The question, however, is which of the two is uppermost in Riyadh’s mind.


If it’s the former, then the stock is likely, I think, to be a perennial laggard.   And it will give a black eye to whatever foreign listing venue it chooses (London and New York are understood to be the frontrunners, although Hong Kong is also big enough to handle an offering of Aramco’s intended mammoth size).

If the latter, the stock may be worth taking a chance on.  After all, it does have a massive amount of extremely low-cost oil and gas reserves.  However, whatever the case, Aramco appears destined to miss the current market, in which companies like Snap and Blue Apron floated successfully,  and which would have been the ideal time for any issuer to come public.

Verizon (VZ) and Disney (DIS)

A short while ago, rumors began circulating on Wall Street that VZ is interested in acquiring DIS.

Yesterday, the CEO of VZ said the company has no interest.

some sense…

The rumors made a little sense, in my view, for two reasons:

–the cellphone market in the US is maturing.  The main competitors to VZ all appear to be acquiring content producers to make that the next battleground for attracting and keeping customers, and

–the Japanese firm Softbank, which controls Sprint, seems intent on disrupting the current service price structure in the same way is did years ago in its home country.

…but really?

On the other hand, it seems to me that DIS is too big a mouthful for VZ to swallow.

How so?

–DIS and VZ are both about the same size, each with total equity value of around $175 billion.  If we figure that VZ would have to offer (at least) a 20% premium to the current DIS stock price, the total bill would be north of $200 billion.

How would VZ finance a large deal like this?  VZ’s first instinct would be to use debt.  But it already has $115 billion in borrowings on the balance sheet, so an additional $200 billion might be hard to manage, even though DIS is relatively debt-free.

Equity?  …a combination of debt and equity?

An open question is whether shareholders in an entertainment company like DIS would be content to hold shares in a quasi-utility.  If not, VZ shares might come under enough pressure for both parties to want to tear up a potential agreement.

dismember DIS?

VZ might also think of selling off the pieces of DIS–like the theme parks–that it doesn’t want.  The issue here is that all the parts of DIS, except maybe ESPN, are increasingly closely interwoven through cross-promotion, theme park attractions and merchandise marketing.  So it’s not clear the company can be neatly sectioned off.

Also, as the history of DIS’s film efforts illustrates, the company is not only a repository of intellectual property.  It’s the product of the work of a cadre of highly creative entertainers.  Retaining key people after a takeover–particularly if it were an unfriendly one–would be a significant worry.

From what might be considered an office politics point of view, VZ’s top management must have to consider the possibility that after a short amount of time, they would be ushered out the door and the DIS management would take their place running the combined firm.  Would key DIS decision makers want to work for a communications utility?

my bottom line

All in all, an interesting rumor in the sense that it highlights the weakness of VZ’s competitive position, but otherwise hard to believe.