Stock price and ROIC: what drives performance?
August 2017 | PROFESSIONAL INSIGHT | FINANCE & INVESTMENT
Financier Worldwide Magazine
August 2017 Issue
What drives long-term company performance? To paraphrase St. Augustine: if no one asks us, we know; if we need to fully explain it, we may not. Most market commentators and financial analysts focus on the top and bottom line metrics of revenue, profit growth and margins as the key components of upside and downside movement and company precification. Analysis of return on capital (ROIC), on the other hand, is usually buried in the investor relations or analyst report. Should this indicator be given a greater role as a lens to analyse not only price shifts but, more importantly, value creation?
Return on invested capital gives a sense of how well a company is using its cash to generate returns. Comparing a company’s ROIC, with its weighted average cost of capital (WACC), reveals whether invested capital is being used effectively. Its raison d’être is, therefore, to focus on effective economic profitability, rather than accounting profitability. Not taking into account economic value added can lead to non-optimal investment decisions and ultimately value destruction.
Let us look at a simple example. As an equity analyst you have been tasked with evaluating two potential investments: company Price, and company Value. Both companies have identical revenue and profit forecasts as well as outstanding shares. Turnover is £100m per annum, net margins at 20 percent with earnings per share (EPS) growth estimated at 5 percent over the forecast period. Relative valuation should return the same P/S and P/E multiples. But is that the whole story? Growth is not free and is a function of either efficiency gains or enhanced investment. There is no free lunch. Companies have to reinvest earnings to generate future growth. In this hypothetical example, we define company Price’s total reinvestment needs (net capex, plus the net working capital delta) as 50 percent of earnings while company Value only requires additional reinvestment of 25 percent to grow at the same velocity.
Thus, company Value generates greater free cash flow – the potential dividend left over after all costs, taxes, debt and investment needs have been met – than its counterpart does. As intrinsic valuation is based on discounting projected cash flows at an appropriate discount rate, ceteris paribus, the value of operating assets of company Value should also be greater, if we assume an identical cost of capital of 10 percent. Traditional multiples that do not take economic gains into account can therefore be misleading. As can a sole focus of growth dynamics.
Looking at ROIC, however, provides an additional framework for decision making. The higher a company’s ROIC, the less cash flow it needs to reinvest to achieve a given level of growth. In our example, company Value generates a ROIC of 20 percent – double that of company Price’s 10 percent.
Distributable free cash flow to equity would be £75m versus £50m respectively. This is important as investors do not get a share of earnings; they get a share of distributable cash. You cannot eat earnings, as they say. They are accounting, not tangible returns. With earnings multiples: caveat lector.
Moreover, fundamental growth rates are also divergent. As Damodaran explains, “With both historical and analyst estimates, growth is an exogenous variable that affects value but is divorced from the operating details of the firm. The soundest way of incorporating growth into value is to make it endogenous, i.e., to make it a function of how much a firm reinvests for future growth and the quality of its reinvestment”. Consequently, fundamental growth is a function of the quality of investment returns and the level of reinvestment. Company Value can expect to sustainably grow at the 5 percent expected rate while for company Price we would project a rate of 2.5 percent. Plugging these numbers into the basic valuation model (Gordon Growth Model) further illustrates this logic. The estimated worth of company Value would be £1.5bn, 225 percent higher than that of company Price – £667m. Put simply, a business or project with high ROIC levels creates significant value for shareholders, which, after all, is the principal objective of corporate finance. ROIC below that of costs of capital destroys value. That is why M&A activity – which generally prioritises EPS over economic profit – has a dubious record in this regard.
Of course, maintaining a value adding ROIC over the long term is a challenge. Think of the economic concept of ‘money on the table’. Some research suggests that that ROIC should trend in line with the cost of capital over time. That is why those companies which sustainably generate high ROIC and thus possess ‘business moats’ to keep the competition at bay are so well valued by investors such as Warren Buffet. Two thirds of companies that earned an ROIC greater than 20 percent were still earning it over a decade later.
It makes sense then that empirical data suggests that a company’s long-term ROIC is a much larger driver of valuation ratios (such as the PE ratio) than growth rates, despite most investors and business owners prioritising growth. Growth is a key performance indicator but should always be juxtaposed with ROIC. Indeed, a study by New Constructs demonstrates that super-economic return of capital has the largest impact on valuations of the S&P500 based on correlation coefficients of a basket of alternative modelled variables. For instance, with an r-squared value of 0.0006, EPS growth over the past five years explains less than one 10th of one percent of the difference in price between stocks in the S&P 500. The r-squared value for ROIC conversely can explain almost 64 percent of price variation. The analysis concludes that “the strength of this relationship is intuitive. If the purpose of capital markets is to promote the most efficient use of capital, it makes sense that the market would reward companies that earn the most profit per dollar of capital invested with the highest valuations”. Other studies have also shown that ROIC is highly correlated with enterprise value/invested capital. Further analysis by McKinsey highlights that many companies with high price-to-earnings multiples have elevated returns on capital but limited growth. This study suggests that, “contrary to conventional wisdom, investors recognise (and will pay more for) the anticipated returns of companies with a strong ROIC, despite their limited growth prospects”. To be clear, we are talking about long-term trends as revenue and earnings noise can certainly create short-term volatility.
Greater focus on ROIC and other economic value metrics can help align managers with the long-term interest of investors and build stronger company foundations. But, just like revenue and earnings, ROIC can also encourage game playing around cutting back investment budgets and prioritising efficiency savings, as well as timing acquisitions, especially if ROIC is measured with beginning-of-year capital. Its components, after all, depend on financial statements and converting accounting earnings into effective cash flows. Invested capital is also not always straightforward to calculate. Thus, broader intrinsic value indicators can and should be used in conjunction with ROIC. Economic profit – calculated as earnings minus a capital charge – can help quantify ROIC and therefore value creation in absolute terms while market value added (the difference between the market value of a company’s debt and equity and the amount of capital invested) can help enhance understanding of the total return to stockholder metric.
In summary then, some financial indicators are created more insightful than others. Or, as McKinsey puts it, “metrics, such as ROIC, economic profit, and growth, that can be linked directly to value creation are more meaningful than traditional accounting metrics like EPS. Although growing companies that earn an ROIC greater than their cost of capital generate attractive EPS growth, the inverse isn’t true: EPS growth can come from heavy investment or changes in financial structure that don’t create value”. Of course, as for all complex issues there is rarely a single answer. At the very least, however, looking at economic value will amplify your financial toolboxes and give you an advantage over those who ignore it.
Growth, especially for early stage companies, is considered the key performance metric. But over the longer term it is not necessarily the leading way to create value for business owners. ROIC, on the other hand, together with other economic value indicators, can provide a more robust framework for strategic decisionmaking. It is also a much more stable metric: over the last 50 years the median ROIC for public US companies has remained close to 10 percent. Growth, both organic and acquisition-led, is much more volatile and should only be pursued if it ultimately drives value. Remember that next time you hear a company director or financial analyst talk about top-line growth or ‘cheap’ valuation multiples. Always enquire about the historic, current and projected economic profitability and the broader value-adding narrative of financial assets.
Adam Paul Patterson is a partner at ALFA Valuation & Advisory. He can be contacted on +55 41 99107 0765 or by email: email@example.com.
© Financier Worldwide
Adam Paul Patterson
ALFA Valuation & Advisory