Thursday, June 19, 2008

What's the value of a Dollar? A business-valuation approach

I recall a witty line in Wired magazine at the climax of the dot-com lather. They were discussing e-biz models where products were being sold below cost under the premise that the difference could be made up in advertizing revenues. Their quip was that the next big idea will be to sell dollar bills for 95 cents and make up the difference in advertizing. Ha. lol. tee-hee. And all that jazz.

I recently gave my take on how a rate change impacts inflation. One voice among a million but I hope it was a more down-to-earth and yet logically linear explanation than most you've read in slick paper, and the broadsheets. If you only get your news from the tube ... what the heck are you doing on there? Today's objective is to take a similarly common-sensical trip down a related tangent: what is causing our currency's current depreciation. Let's dive right in:

Pretend the whole US is a big company. The exchange rate of the Dollar (vs. all other world currencies) would be it's stock price Just like any other stock, the drivers would be:

#1 - Consensus expectations of Credit-worthiness (=ability to pay back the national debt). If US Inc. is on solid financial ground, the stock price goes up.
#2 - Consensus expectations of Earnings (=GDP). Back-to-basics stock valuation says a stock should reflect the discounted sum of all future cash flows.
#3 - Consensus expectations of Growth (=GDP growth rate). A growth stock carries a higher multiple (of price to earnings) under the premise that earnings tomorrow will be much higher and thus #2 above will mathematically have to increase. Investment is the best way to drive this factor.

As simplistic as it sounds, I'd argue that those are the drivers of the exchange rate. There are nuances and other factors to be sure. Allow me to put some oft-overlooked meat on those bones with a more complete story. As the biggest debtor on the planet, the US is constantly refinancing itself. This is done by the US Treasury which sells billions of dollars in IOUs every day. They promise to pay some back in less than a year (called T-bills). Others don't come due for 1 to 30 years (T-notes and T-bonds). Depending on the due date (aka maturity) they pay a different interest rate.

Most of the IOUs are issued to refinance the old ones maturing today, but there is a net increase every day of $1.5 billion. Anyone purchasing these debts would have to ask themselves: What's the chance the US Treasury would go broke and fail to pay me back? Currently, the chance is pretty low, but the more we borrow, the more worried people get ... and down goes the stock price of US Inc.

As people get nervous about the total debt, they refuse to buy the IOUs at the current interest rate. This forces the Treasury to (in effect) increase the interest rate they'll pay for the same amount of debt. Thus, the second factor of concern is the average interest rate on that debt. In our US Inc. analogy, this is the weighted average cost of capital (WACC). As the cost of borrowing goes up, so does the percentage of earnings eaten by interest payments. This means less money is left over to invest in the future. US Inc. currently spends nearly 10% of revenues just on interest.

But wait, there's more! As a rule of thumb in finance, you should match the maturity of your debt with the underlying asset or project. If you're gonna buy a car that will last 5 years, it would be dumb to take out a 10 year loan to pay for it, right? It would suck to still pay on a car that's long gone, especially since you'd have to start paying for the new car loan on top of the old one. It would be equally dumb to start building a million-dollar house if you were only able to borrow $500k. You'd run out of money and have to crawl back to the bank to beg for more. The same should apply to US Inc. Say the Federal government wants to install new Air Traffic Control systems which will last 10 years. This should be fully financed at the outset and the debt should mature in 10 years. It would be nice to pay off the loan on that project in 5 and just have a bunch of "free" cash sitting in the bank to finish the project ...

But #1 - that's unnecessarily expensive since you paid interest and fees to borrow money which then just sits and collects dust. Better to borrow the money in little pieces as you need it. #2 - you can only pay back early if you have the money. The Treasury doesn't. This is why the total debt keeps increasing. These days most of the Treasury's debt has a 10-year maturity, but if you average out the dollars borrowed at each maturity, you find out that the average maturity on US debt is under 3 years. And this brings us to our third factor of concern: decreasing average maturity of debt means decreasing likelihood of repayment. If you wanna understand why, look at Bear Stearns, whose average maturity dropped from over a year to under a week just before they imploded. In other words, no one would lend to them for more than a few days, and it was too hard for them to repay and re-borrow every night just to make ends meet. Let's hope the US Treasury learned a lesson from this.

Decreasing debt maturity also means that politics can have a stronger influence on the finances of the country. Re-financings are opportunities for politicians to either a) do the right thing and invest in tomorrow. For example by decreasing spending so we can pay down the debt and decrease the percentage of future budgets dedicated to interest. Or they can do b) which is the politically-expedient thing: and hawk tomorrow's revenue at a deep discount and spend Spend SPEND! today. The longer the maturity, the less their ability to mess up the country's finances before they're back out on the relatively harmless lecture and lobby circuit.

Enough for today ... but I promise to sharpen my pencil and add to this concept in upcoming blogs!

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