We looked briefly at return on capital and examined how high return on capital companies can produce high returns for the investor. Now I want to delve into this a little deeper.
It is well known that the true value of an asset is the net present value of all future cash flows the company will have (more exactly, cash flows that will eventually return to owners and investors at some point). Specifically, it is the net present value of all free cash flows. The free cash flow is essentially all the cash a business earns directly from the business it does minus whatever must be reinvested back into the business to keep it running and possibly growing, called capital expenditure.
In the idealized scenario, there is a forecast period during which cash flows are growing at some rate, but then the company must inevitably settle into a long term growth rate as the period of consideration stretches out to very long times. This growth rate cannot be higher than the growth rate of GDP forever, or the investment will eventually become the entire economy over time. So usually, the forecast period (maybe 5, 10, 20 years) includes a different, possibly variable growth rate for cash flows, and then there is a low and constant growth rate for the terminal value calculation for the time period that stretches out beyond that. So the total value of the investment is then
Total value = Value created in forecast period + Terminal value created beyond the forecast period
The terminal value often makes up a substantial portion of the total value, so let’s focus on that. The Gordon growth model gives a well-known terminal value formula:
V = FCF x (1+ g) / (d-g)
where
V = value of all future cash flows, or just value
FCF = the latest free cash flow (dividends are also sometimes used)
g = terminal growth rate of free cash flow
d = discount rate of free cash flows
To give an example, if a company has a free cash flow this year of $100 million, a terminal growth rate of 2%, and a discount rate of 10%, the terminal value of the company would be
V = $100,000,000 x (1 + 0.02) / (0.1 – 0.02) = $1,275,000,000 (or $1.275 billion)
For this formula to work, the growth rate must be less than the discount rate or the cash flows grow faster than they can be discounted. This is an unrealistic situation, since the company would be worth an infinite amount.
The discount rate needs some discussion. In the real world, you don’t only just invest in one thing, but instead you forgo all other investments when you make your choice. You could have invested in something simple and low risk, like treasury bonds at 4% yield, so if you make a choice to invest in something risky with a guaranteed less than 4% return, you have lost out on some value that you could have had with near certainty. Similarly, if you take a large risk, you require a larger return to justify this because there is a chance that your investment will decline in value instead of grow. In addition, inflation will erode the value of your future cash flows. Finally, a sum of money sooner is worth more than the same sum at a much later date, because of all the added opportunities to use it at the earlier time for investment or other purposes. The discount rate represents the minimum rate of return you require to justify making the investment. Another way to think about it is the time value of money or opportunity cost of money. You discount all future free cash flows from the future back to today at this rate to get the net present value.
So what do we use for the discount rate? The most common discount rate is called the Weighted Average Cost of Capital (WACC for short). To explain, we need to understand the capitalization structure of an investment. We are going to use a company as an example. A company’s capital is money put into the business to get it started, buy equipment, etc. It can be money that is put in when the company is first started, and it can be put in later when the company needs more money to purchase, say, a new factory to expand operations. Capital is usually composed of one of two things: equity (we will call this E) and/or debt (we will call this D). Debt is money that is loaned to the company by lenders (banks, debt investors, etc.) where they expect to be paid back at a defined rate which includes repayment of the original amount loaned plus some interest. Equity is money given to the company by investors, or earnings that investors have rights to but which the company retains on their behalf to further improve the company’s prospects (called retained earnings). The weighted average cost of capital is just
WACC = Ce x fe + Cd x fd
where
Ce = cost of equity
Cd = cost of debt
fe = fraction of company’s capital structure that is equity = E/(E+D)
fd = fraction of company’s capital structure that is debt = D/(E+D)
This represents a blended average cost of the company’s capital. The cost of equity and the cost of debt are typically composed of a required risk free rate of return plus a risk premium that represents the required rate above a risk free investment that these investors demand to justify taking the risk.
So, to take an example, let’s say a company’s capital structure is 60% equity and 40% debt. At this level of debt the cost of debt is 6% and the cost of equity is 10%. The weighted average cost of capital for this example company would be
WACC = 0.10 x 0.60 + 0.06 x 0.40 = 0.084 (or 8.4%)
Now that we understand weighted average cost of capital a bit, we can go back to our original equation and rearrange terms. We can rewrite the Gordon Growth model equation above into a more informative format for our purposes
V = Invested capital x [1 + (ROIC – WACC) / (WACC – g)]
where ROIC = return on invested capital
Let’s do a couple of examples here. First, let’s try an example where return on invested capital is greater than the weighted average cost of capital. Let’s say that company A has $100 million in invested capital, an ROIC of 15%, a WACC of 7%, and a terminal growth rate of 3%. The terminal value of company A is
V = $100,000,000 x [1 + (0.15-0.07)/(0.07 – 0.03)] = $300,000,000 ($300 million)
Next, let’s try an example where return on invested capital is less than the weighted average cost of capital. Let’s say that company B also has $100 million in invested capital, an ROIC of 4%, a WACC of 7%, and a terminal growth rate of 3%. The terminal value of company B is
V = $100,000,000 x [1 + (0.04 – 0.07)/(0.07 – 0.03)] = $25,000,000 ($25 million)
Here we can see that if we do not earn a return on invested capital above the weighted average cost of capital, the value of the term in brackets will be less than one, and the terminal value will be less than the capital that has been invested, as in the case of company B. The value could even be negative if this situation is bad enough, but it would not persist forever, because the company would go out of business when investors eventually refuse to invest or lend to such a company, and it uses up all of its funds in wasteful pursuits. The growth rate, g, must be less than the WACC or these cash flows will increase without bounds. That is unrealistic because the cash flows grow faster than the discounting. In this case, the company consumes all world capital eventually and the WACC would have to rise due simply to supply and demand for capital. Further, growth must eventually slow to at or below GDP in the very long term.
This version of the formula is very interesting, because it suggests that growth for growth’s sake is not the aim. If a company is not earning a return on capital above its weighted average cost of capital in the long term, it actually destroys even more value by trying to grow faster! If you are going to get excited about a company claiming extraordinary growth, you had better be sure that it will earn returns on capital above the weighted average cost of capital.
This formula tells us even more interesting stuff. What can a high return on capital business do to increase its value? Well the numerator of the term in the above equation will already be large (ROIC – WACC), so increasing the ROIC won’t change this number as much. But the denominator (WACC – g) will greatly increase value the closer it gets to 0 (because a number divided by a very much smaller number will be large). So companies that have high ROIC can improve their situation most by focusing on how to grow at sustained high ROIC. This is often quite a challenge however in the very long term.
What about companies that have a low ROIC? What can they do to improve their situation? Well in the equation above, for a company with low ROIC, the numerator will be small or even negative (ROIC – WACC), so rather than focusing on growth, they should focus on increasing their ROIC.
Now what happens if we select extremely high quality businesses? Well, they tend to have high earnings quality, good credit ratings, etc., so their WACC is lower on average. The risk premium that equity investors and lenders demand for such a stable business tends to be lower than for other more risky ventures. This isn’t universal, but the general trend is there. One example that runs counter to this is for high quality companies that are growing fast and making a lot of investments. They may choose to issue a lot of equity to fund the purchases and/or pay valuable employees. However, equity tends to be more expensive than debt in most normal cases (a notable exception being if the company’s debt is rated very low or junk). For such a company issuing a lot of equity, their WACC can be higher than expected for a high quality company, all else being equal.
If a high quality business tends to have lower WACC, this improves both the numerator (making it larger) and denominator (making it smaller) of the term in the equation above in brackets, increasing the value created. In addition, high quality businesses by our definition have higher returns on capital which increases the numerator of the above equation and increases value. Growth for high quality businesses can be all over the map, but for terminal value where the formula above applies, they will eventually settle into a more restrained growth. However, you can get hints from this equation that over all time periods, high growth is good for high return on capital businesses, and very bad for businesses with a return on capital that is too low.
The above equation, derived from the Gordon Growth Model, is an idealized situation. Real cash flows do not march steadily upward, year after year at a perfectly defined growth rate. There is some volatility in earnings. Even if this volatility is less than average in the case of high quality companies, it is still present. The final value of the company this model predicts tends to be quite sensitive to your assumptions about long term growth also, making estimations of the real value difficult. Nevertheless, this equation, while not perfect in application to real world situations, gives you a great idea about what knobs can be turned to crank up value, and what will also destroy value. So the equations above are showing us the gist of what is important in the real world. This is more important to understand than calculating a precise value for a company or stock using these formulas.
We want high return on capital businesses that earn returns on capital above their weighted average cost of capital. The more this difference (ROIC – WACC) is, the more return you will have from your investment. Growth is only good if your investment’s return on capital is above its weighted average cost of capital, otherwise growth is bad. For companies that have financial troubles, use too much debt, have poor earnings quality with a lot of volatility, their weighted average cost of capital will be higher, and this will greatly erode the value that they can generate over time. Therefore, the company should choose an optimal capital structure – too much equity can be expensive, but too much debt will lead to downgrades in the company’s debt rating and then debt will become too expensive.
So to summarize, in general, we solve a lot of problems by limiting ourselves to the highest quality businesses with durable sustainable returns on capital, and by seeking to buy the most cash flows for the lowest cost from these kinds of businesses. This combination of purchasing such companies at good value, coupled with earning returns on invested capital well above the weighted average cost of capital, will, over time, earn us outstanding returns.
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