How ROIC Builds Value
The Power of Compounding
by Dale Wettlaufer (TMF Ralegh)
ALEXANDRIA, VA (Oct. 16, 1998) -- Given our explanation of the Boring Ratio in Wednesday's Bore report, a number of different assumptions come into play in the shorthand way we look at things. First, the price we pay is considered. We want value, but we will pay more than what traditional value investors might pay. We think price/revenues, price/book, and even price/earnings ratios are poor indicators of value if you assign an arbitrary cutoff point and don't look at things above that point. Yet, that doesn't mean we're not careful about the price we pay. We're almost hypersensitive to value if you ask people who know us.
That's why we don't have a preference for growth over no-growth companies, as long we can get the right price for either. Getting the right price means buying something at a price so that cash flows get to a point where the return on original invested capital is very large and where additional cash flows from new capital investments beat the cost of those new investments. There are a number of ways to express this in long-term valuation models, but one place we don't see this expressed all that well with short-term models is the P/E ratio. Buying a commodity metals distributor at 5 times earnings isn't necessarily a better investment than buying Microsoft at 60 times earnings.
The shorthand indicator we introduced the other day is a ratio, like the P/E ratio. However, it expresses the relationship between the actual capital efficiency and profitability of the company and the price we're paying for the cash stream that comes out of the company. Price/earnings only expresses what we're paying for a cash stream that can come out of a company.
Why should there be a shorthand way to express this? Outside of the fact that many of us cannot do discounted cash flow analyses in our heads, it's the construction of the ratio that tells something about a business that a P/E won't tell us. For example:
Say we find a company priced at a P/E of 10 and that company doesn't need any additional capital expenditures or working capital additions to generate $1 in earnings per share each year going forward. Without any debt in the purchase price and with no excess cash that reduces the purchase price of the business (since I have to make those qualifications, we see another reason why using equity market capitalization as the numerator is inferior to using enterprise value), we know right off the bat that we can recoup the purchase price of the company in ten years. The yield on the price we paid is 10% per year. The period needed to recoup the investment will be less if we invest the earnings elsewhere rather than consuming all those earnings.
Over a ten-year holding period, the company will generate a dollar of earnings per year. Discounting each of those years' cash flows at 10%, the present value of the cash flows will be: $0.91, $0.83, $0.75, $0.68, $0.62, $0.56, $0.51, $0.47, $0.42, and $0.39 = $6.14.
Now, say we reinvest those cash flows in the stock market or some other investment that returns 10% per year. Reinvesting those cash flows at 10% per year, the future value of those cash flows will be: $2.35, $2.14, $1.95, $1.77, $1.61, $1.46, $1.33, $1.21, $1.10, and $1.00 = $15.92. Add a sale of the business at 10 times earnings -- in the parlance of discounted cash flow models, this is the residual value -- and we add $10 to the above for $25.92 in capital at year 10. Notice that works out to a 10-year compound annual return of 9.99%, equal to the rate of return we get if we reinvest the cash flows at a certain rate of return.
Now, say we look at a company with the same earnings but instead pay 20 times earnings. If the company doesn't grow, we obviously are going to have a less satisfying experience than the one above. But if the company's return on invested capital (ROIC) is 20% and it can continue to offer a return of 20% on all new invested capital, then we would have made a better deal than above. Starting off here, we have a Boring Ratio of 20% divided by 4, or 5%.
The present value of the sum of the future earnings of this company will be the same as the company above if the company doesn't grow, but we're going to reinvest those cash flows in the company. Each year's earnings will look like this:
$1.00, 1.20, $1.44, $1.72, $2.07, $2.48, $2.98, $3.58, $4.29, $5.16, $6.19. That works out to be the same thing as the original dollar of earnings invested at a compound growth rate of 20% -- equal to our return on invested capital. Now, those aren't earnings we can take out of the business and put in our pockets and invest elsewhere. We're growing this business.
However, at year 10, the capitalized value of our business is at least worth $61.19, more than six times what the other business sold for at year 10, and 2.36 times the amount of capital the other business owner had accumulated at year 10. Even if we don't have a buyer lined up for the business at year 10, it's worth this amount because alternative investments yielding 10% per year would require $61.19 in capital to generate the same level of earnings our business is generating in the ending year.
If we happen to sell the business at 20 times earnings and four times invested capital, we will end up with $123.83 in capital. Invested in the same sort of vehicle in which the above business owner had invested his ending capital, we would generate yearly income of $12.38 while the other guy would be generating yearly income of $2.59. So, whether or not we're selling our business, we're generating anywhere from 2.4 to 4.8 times the other guy's annual income during our retirement.
Such is the power of compounding. By choosing the seemingly pricier investment in year one, we've done a heck of a lot more to improve our lot in life than choosing the "value" company in year one. Now, the "Boring Ratio" isn't a way to value things; it's just a shorthand measure. And if we never use the term again, that's fine. We're not trying to institutionalize something. (Alex doesn't even know I've invented this thing.) We're just trying to demonstrate, with a (hopefully) simple example, how compounding works and one measure we think is important in looking at a company.
This is why we focus on cost of capital. The high ROIC investment will generate much more value for us than just investing in an index fund, or a competing investment offering a 10% rate of return, or even a "value stock." When you take a company like Microsoft and pay 70 times earnings while the rest of the world wails about it being overpriced, the company's ROIC and future growth prospects play a huge part in its valuation. That's a given. But if you have insights into what the company can do in the future, 70 times earnings might be cheap if the company can keep compounding capital at 50% per year for a number of years. As a function of determining how much value a company can build for investors, ROIC and weighted average cost of capital (WACC) calculations are vital to our way of looking at the world.
For discussion, as always, please visit the Boring message board.
10/01/98: The New Boring Port Transitions Facts
Stock Change Bid ANDW + 9/16 14.44 CGO +1 27.75 BGP + 3/16 25.06 CSL +2 1/8 38.13 CSCO -1 9/16 55.38 FCH + 1/16 21.44 PNR +1 13/16 33.38 TBY - 1/16 6.13 |
Day Month Year History BORING +1.11% -1.58% -15.78% 5.97% S&P: +0.85% 3.88% 8.86% 69.95% NASDAQ: +0.62% -4.30% 3.22% 55.72% Rec'd # Security In At Now Change 6/26/96 225 Cisco Syst 23.96 55.38 131.16% 2/28/96 400 Borders Gr 11.26 25.06 122.65% 8/13/96 200 Carlisle C 26.32 38.13 44.82% 3/5/97 150 Atlas Air 23.06 27.75 20.35% 4/14/98 100 Pentair 43.74 33.38 -23.70% 5/20/98 400 TCBY Enter 10.05 6.13 -39.02% 11/6/97 200 FelCor Sui 37.59 21.44 -42.97% 1/21/98 200 Andrew Cor 26.09 14.44 -44.66% Rec'd # Security In At Value Change 6/26/96 225 Cisco Syst 5389.99 12459.38 $7069.39 2/28/96 400 Borders Gr 4502.49 10025.00 $5522.51 8/13/96 200 Carlisle C 5264.99 7625.00 $2360.01 3/5/97 150 Atlas Air 3458.74 4162.50 $703.76 4/14/98 100 Pentair 4374.25 3337.50 -$1036.75 5/20/98 400 TCBY Enter 4018.00 2450.00 -$1568.00 1/21/98 200 Andrew Cor 5218.00 2887.50 -$2330.50 11/6/97 200 FelCor Sui 7518.00 4287.50 -$3230.50 CASH $5750.59 TOTAL $52984.97