Summary
- On October 25, MSCI reported quite strong 9M numbers and, for the moment, defended its high multiples (LTM P/E about 44).
- In this article, I focus on a high-level valuation of MSCI to decide if it’s worth analyzing the stock in more detail.
- Using a standard DCF-WACC model, market data for interest rates, and reasonable estimates for future fundamentals suggests massive overvaluation (theoretical downside of 54%).
- The result is very similar when comparing MSCI to common valuation multiples of a peer group. Depending on the multiple, the company trades at a premium of up to 60%.
- MSCI is undeniably a very high-quality company. But at the current levels, the company just appears way too expensive. So I am not yet interested.
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Introduction and MSCI's Business
You don't need much skill to identify MSCI ( MSCI ) as an outstanding business. As we all know, the company is famous for its wide-ranging indices (about 60% of revenues). In addition to that, MSCI is also well-positioned in all kinds of investment analytics (25% of revenues), and the strong-growing field of ESG solutions (10% of revenues). Almost all revenues are either from recurring subscriptions or tied to linked assets under management (as of September 2022, slightly more than $1 trillion were linked to MSCI indices).
Since I am working as a portfolio manager, I obviously knew the products and indices of MSCI very well. However, I still only started to really think about the company in the beginning of this year when I reviewed a research paper about the power of index providers on my website. The paper shows 1) that the index market is a consolidated oligopoly (S&P, CRSP, FTSE, MSCI, and NASDAQ captured about 95% of linked AuM as of 2019), and 2) that index providers are heavily profitable. According to the analysis, ETF sponsors forward about 1/3 of their management fee to index providers in the form of licensing fees. So if you pay 10bps for an ETF, about 3.3bps end up in the top-line of the index provider. These were just, in my opinion, the most important results. For more, feel free to also check the paper .
Needless to say, this is an unbelievable and attractive business model. The marginal cost of linking an additional dollar to an index is de-facto zero but revenues increase with growing AuMs. In addition to that, the paper also shows that ETF-investors care about the index and prefer funds linked to brands like MSCI or S&P. Index providers therefore benefit from tremendous scale, strong brand power, little competition in a consolidated market, and very sticky products. It cannot get much better than that and from a fundamental perspective, indexing is probably one of the most attractive businesses in the world (for the incumbents).
Since MSCI is one of the "purest" publicly traded index-companies, I became interested in the stock. Whenever I find such an interesting fundamental idea, I usually start with a high-level aggregate valuation to see if the stock is reasonably attractive and worth the time to analyze it further. In this article, I want to share this work and focus on the aggregate and quantitative valuation of MSCI. Spoiler: even the best businesses in the world can get unattractively expensive..
MSCI - Discounted Cash Flow Valuation
Most of what I know about valuation comes from the outstanding lectures of Aswath Damodaran. Full disclosure, I closely follow his methodology. That said, I obviously still did all the analyses myself and I have not used any third-party services except for raw data.
To start with, I value MSCI via a standard DCF-WACC model. Since MSCI generates substantial (recurring) cash flows from its operating activities, this approach is actually quite easy to apply here. The following slide summarizes my model and the most important assumptions.
To mention the key result right ahead: based on this model and, in my opinion, quite optimistic assumptions about future fundamentals, MSCI currently looks massively overvalued. I estimate a "fair" value of $213.31 per share, which is about 54% lower than $460.91, the last stock price from November 4, 2022. This is of course a drastic deviation, so let's see how I arrive at this result and how to interpret it.
DCF-WACC Valuation Summary (Current Financials from MSCI IR Website; Estimates and Calculations from Author)
I have explanations for the most important assumptions already on the slide, so I will rather give you some more background, model-logic, and interpretation at this point.
Forecasts and Assumptions
I already mentioned it earlier, but please note that my goal with this model is to generate a first logical assessment of MSCI's current valuation to decide if it's worth to go into more detail. Therefore, I honestly don't spend too much time on sophisticated forecasts. My numbers are mostly inspired by the upper end of the current analyst consensus and long-term estimates from current industry statistics. Basically, I want to see if there are attractive deviations between the price and (estimated) value when I just plug in the market consensus.
Why is the Value so Low?
54% downside is obviously very drastic and almost certainly unrealistic (Yes, I created this model and still stay that it is probably unrealistic). So how should interpret this result? First of all, DCF models are always an abstraction of reality (this is the purpose of models, so don't blame them) and very sensitive with respect to a lot of assumptions. So should we expect MSCI to lose more than half of its value over the next months? Probably not.
But in my opinion, we should carefully interpret the sign and magnitude of this number. Using widely accepted methodology, current market data for interest rates, and reasonable (if not optimistic) fundamental forecasts, my best estimate for the "fair" value of MSCI is significantly below the current stock price. To me, it really doesn't matter to much if the downside is 54% or 27.8%. What matters is the fact that this number is way below the current stock price. As I mentioned earlier, this is my first check to decide if it's worth the time to analyze the idea any further. Given the magnitude of this result, my personal answer for MSCI, as of November 4, 2022, is definitely "no".
Stress Tests and Model Logic
I don't want to be arrogant and after obtaining such a drastic result, I obviously asked myself where I could be wrong. I figured out that the main point I deviate from the "market" (I looked at some freely available analyst reports) is MSCI's need for reinvestment.
As of 2021, MSCI earned an outstanding 41.8% Return on Invested Capital (RoIC). This is of course a direct result from its wonderful fundamental characteristics and strong competitive position. With this number, MSCI is also at the very upper end within its own GICS Sub-Industry (I calculated industry statistics on Bloomberg but I am unfortunately not allowed to share the data at this point). In my model, I fully acknowledge this strength of MSCI. As you can see in the last line of the table, the RoICs implied by my estimates for profit margins and reinvestment are all in the ballpark of 40%. So I basically say, "Yes, MSCI is a wonderful business and I expect it to continue being a wonderful business." What I don't believe, however, is that MSCI can become even more wonderful. Businesses with >40% RoIC are world-class and even just continuously reinvesting at such high rates of return is very ambitious.
So I think it is just not realistic to assume even higher RoICs for the future. Yes, MSCI has a strong position and tremendous growth potential in ESG. Yes, the indexing business will probably continue to do very well. But is this really sufficient to lift the RoIC from "outstandingly high" to "even more outstandingly higher". I obviously don't know but I don't think we should consider this scenario as our best estimate. Even the best businesses are vulnerable. For example, competition and price pressure in the indexing market already starts increasing as cheaper competitors like Solactive or incumbents like Bloomberg also ramp-up index offerings.
I talked to several people in the industry and got the impression that there is now some price awareness and sensitivity for indexing. This is obviously a threat for MSCI's hefty margins. Further note that mighty entrants like Bloomberg also have their competitive advantages. For example, the Bloomberg Developed World Index is basically identical to the MSCI World with respect to performance and composition. But the catch is: constituents and weights of the Bloomberg index are included for Bloomberg's 200,000+ subscribers whereas users would have to pay an additional fee for MSCI data. As I am a Bloomberg user myself, I can tell you that this is a key advantage because you need clean and up-to-date data for the benchmark indices of your funds. Of course you can pay for MSCI. But since Bloomberg indices are already included in the terminal subscription and are performance-wise essentially similar to MSCI, I prefer to use them whenever possible.
Relative Valuation/Multiples
Comparison to Peers
As the result of the DCF-model is admittedly quite extreme, I also looked at MSCI from a relative perspective. The following slide summarizes three common valuation multiples for MSCI and a (arguably somewhat arbitrary) peer group of "comparable" companies.
Common Valuation Multiples of Peer Group (Data from TIKR)
We can of course debate a lot about the peer group and whether those companies are really comparable. But as for the DCF model, I rather want you to focus on the sign and magnitude of the results. No matter which multiple you look at, MSCI looks always significantly more expensive than the mean and median of the peer group. Depending on the multiple, the premium reaches up to 60%.
All else equal, a 60% multiple-premium suggests about 38% downside for the stock price. This is not as extreme as my 54% DCF-estimate but goes in a very similar direction. Of course, MSCI may be of better fundamental quality than this peer group and could deserve a higher multiple. I absolutely don't deny that but I still want to mention the same logic as above. It doesn't matter if the premium is 61% or 31.2%. In my opinion, the point is that MSCI looks expensive from all angles and that even for a wonderful business like MSCI, a 60% premium to peers requires a lot of optimism.
One technical note to the peer group. I fully understand the critique of this somewhat arbitrary peer group. I also don't like analysts who are not transparent with the construction of their peer groups. Therefore, I did the same analysis with the "Bloomberg Best Fit" peer group. I also did it with all companies in the global "Financial Data & Exchanges" GICS Sub-Industry group. I am unfortunately not allowed to share this data but I can tell you that the general direction and magnitude of the results doesn't change. Across all multiples, MSCI still looks expensive versus all its peers.
Comparison to History
In the last step, I also looked at the current trailing P/E ratio versus MSCI's own history. The following slide shows the chart since 2018.
MSCI LTM P/E Ratio History (Data and Chart from TIKR)
After the COVID-crash in early 2020, MSCI was one of the top performers and became continuously more expensive. The P/E ratio ultimately peaked at more than 80 in late 2021. Since the beginning of 2022, it has almost halved and currently stands at 44.48. Compared to the depicted history, this looks quite okay (the mean is 49.88) and corresponds to the levels of 2018.
So this is the first data point that somehow contradicts with my other analyses. Compared to its own 4Y-history, the current P/E is below the historical mean and some people therefore consider it attractive. I obviously cannot (and will not) deny this fact.
But I want to mention a few points. First, the current P/E of 44.48 is still considerably above the range of 30-40 where MSCI traded in 2019, the "cheapest" period in this graph (data from TIKR). Second, the very high P/E ratios from 2020 and 2021 are probably a bad estimate for the future (I think nobody can deny that the last years were a very special period for markets). Third and finally, a P/E ratio of 44.48 is by all standards very high. The S&P 500 currently stands at a P/E ratio of 18 to 19. Of course, MSCI is of higher fundamental quality than the index. But once again, the premium is quite drastic. Also note that we are now living in a very different world with respect to interest rates. In 2018, the 10Y treasury yield was between 2.5 and 3%, now we are at >4% and maybe not even done yet. Again, I also believe that MSCI is worth some premium. On the other hand, I am also convinced that a P/E ratio of >40 is quite ambitious in today's market.
Conclusion
I know, I haven't written to much qualitative about the company and mostly focused on financials and valuation. But I do think I got along the message of the competitive dynamics of the very attractive indexing business. Nevertheless, I apologize to everyone who found this boring (although I suspect that those people didn't make it to this final paragraph).
There is a quote by Warren Buffet that something has to "scream at you that you have got this huge margin of safety" to be an interesting investment. Given what I presented here for MSCI, I think that is just not true. It is a wonderful business of extremely high fundamental quality, but the price and valuation appears too expensive.
For further details see:
MSCI: Even Quality Can Become Too Expensive