Incremental returns that are enticing
I like to develop a good feel for the economic performance of companies I invest in. Economic performance carries with it a sense of how successful a company (and company management) are in producing economic benefits for the shareholders. It focuses on effective use of the capital invested in the company.
For economic performance some investors look for a five year record of increasing sales and earnings. They feel this track record is a good indicator that the company will continue to grow its sales and earnings. This is a mistake. It is an example of our human tendency to predict the future by extrapolating from the past; a case of mistaken inductive reasoning. It is driving while looking in the rear view mirror.
Growth per se is overrated. As Warren Buffett has said: ‘’Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other works, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.” (Buffett/Cunningham, 1998) p86. (Emphasis added)
Successful investing does not lend itself to the mindless application of formulas or ratios. The performance indicators I look at here and in the Motherlode are tools to help direct and focus the mind. As Warren Buffett tells us, our job is to carry out a business analysis, not a security analysis. A business analysis is as much, if not more, a qualitative analysis: as compared with a quantitative analysis. It must be done with common sense and business sense. We must always remain skeptical of the numbers. As Warren Buffett put it in his 1986 Chairman’s letter: “…accounting is but an aid to business thinking, never a substitute for it.”
In the most generic sense, return on capital (ROC) is the profit earned by the business divided by the total of financial capital employed in the business and expressed as a percent. The financial capital is comprised of both debt capital and equity capital.
We can set out the formula which I think best captures what we are trying to measure:
Return on capital (ROC) = net income/capital employed (as a percent)
For ‘net income’ some analysts use Net Income as defined by the Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS), i.e. Net Income Attributable to Common Shareholders. Some analysts use adjusted net income, excluding certain one-time items. Some don’t use net income from the company’s statement of operations. Instead they use earnings before interest and taxes (EBIT); and, some use net operating earnings after taxes (NOPAT). For present purposes we don’t need to think about these differences, just be aware they exist. They are discussed elsewhere in the Motherlode. See here. As well, in an age of company investment in intangibles of lasting value that are expensed against reported income and do not appear on balance sheets we need to be alert to serious problems in taking reported assets and the book value of equity, at face value. For a discussion of this issue, see here and here.
Anyway, to start our assessment of economic performance we need a figure for ROC. This is available from various services including sell side analysts.
Cost of Capital (WACC)
It is nice to know from ROC percentages how profitable a company is relative to its peers. But, we want to know more than that. A substantial spread between ROC and a company’s cost of capital over an extended period of several years and through business cycles is usually indicative of a sustainable competitive advantage; in other words, a moat. It is also likely to indicate a company with potential to produces substantial Owner Earnings and opportunities to reinvest excess capital at high rates of return.
Economic performance is thus measured by examining the sustainable ROC of a company and subtracting from it the company’s cost of capital. Since companies have both equity capital and debt capital, we need to understand a company’s Weighted Average Cost of Capital (WACC). It is weighted between equity and debt depending on the proportion of each.
Understanding the WACC is useful for both investors and management. In order to determine the advisability of capital projects many corporations use a rule of thumb that the return on the capital for projects should significantly exceed the company’s cost of capital – that is, the cost to the company of raising capital in the market. For investors the company’s overall sustainable ROC compared with its WACC is really useful in identifying superb businesses.
As noted, a calculation of cost of capital requires a blending of the cost of both types of capital. The cost of the company’s bonds is straightforward enough. The calculation of the company’s cost of equity capital requires a formula to produce the risk-weighted rate of return required by equity investors in the company. In essence the formula will have to capture the idea that the cost of equity equals the risk free rate of return plus a premium expected for risk. It will be immediately apparent that this is the same concept as the equity risk premium discussed elsewhere. This is also a field that the Capital Asset Pricing Model (CAPM) has messed up.
As a brief introduction to this topic, consider the following quotes from Charlie Munger who is Warren Buffett’s partner at Berkshire Hathaway:
“Of course capital isn’t free. It’s easy to figure out your cost of borrowing, but theorists went bonkers on the cost of equity capital.” “A phrase like cost of capital means different things to different people. We just don’t know how to measure it. Warren’s way of describing it, opportunity cost, is probably right. The answer is simple: we’re right and you’re wrong.” “A corporation’s cost of capital is 1/4 of 1% below the return on capital of any deal the CEO wants to do. I’ve listened to many cost of capital discussions and they’ve never made much sense. It’s taught in business school and consultants use it, so Board members nod their heads without any idea of what’s going on.”
Fresh thinking on WACC
When a company’s stock is more volatile than the average stock in the S&P 500, the traditional finance theory view, based on the Capital Asset Pricing Model (CAPM), is that a company’s cost of equity is higher since the stock is considered more risky and thus raising equity would be more expensive. This is fundamentally flawed; volatility is not a valid proxy for risk. This approach causes the cost of equity capital to be calculated at more than it should be for some companies and less for others. It can perversely show a very high cost of capital for a company with a pristine balance sheet and solid sustainable earnings whose stock just happens to be volatile. It could borrow at cheap rates and if it did borrow, its cost of debt as part of the WACC would bring the total WACC down significantly. But, if its stock price is volatile its traditionally calculated WACC can be quite high.
An old buggy whip company playing out the string may be a very low volatility stock but it may be a high risk investment with a low price earnings ratio and its cost of equity capital should be correspondingly high.
If the CAPM is flawed, what can replace it? The best approach is to assess whether companies in general and relatively, the company in question, can raise money cheaply in public offerings. When shares are trading on the stock exchange at ridiculously high price earnings ratios, one could say the cost of equity is generally cheap. If our company is trading at a higher price to earnings ratio than the S&P 500 average, it would be raising equity cheaper than the market as a whole.
Putting numbers on it
This post has more or less scratched the surface. It has all been in aid of trying to develop a sense of how we identify the economic performance of companies. We have touched on ROC and WACC and what the concept of a company’s cost of capital is.
ROC numbers can be quite misleading. They can be unduly flattering to management. Companies with ROC percentages above 15 or 20 are worth looking at further.
In the interest environment at the date of this writing, a weighted average cost of capital (WACC) should range from say 6% to say 9% for the most financially strong companies to figures well over 10% and even over 15% for less financially strong companies. See elaboration here.
The purpose of this post has been to highlight the subject of economic performance and raise a few issues regarding its use. Hopefully when analysts are talking about Return on Capital (ROC) and Weighted Average Cost of Capital (WACC) readers will know what they are talking about and understand their uses and weaknesses.
This post has been part of a series on identifying superb companies. Others in the series are found here.
To read more deeply on the subject of how to go about finding the seven footers see the Motherlode Part 6: The Hallmarks of Superb Businesses
And for what we can learn from a company’s financial statements about its financial strength and profitability look at Chapter 35. Capital Structure, Strength and Economic Performance.
Want to dig deeper into the principles behind successful investing?
Click here for the Motherlode – introduction.
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