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April 20, 1999
Equity Isn't Free
By
In Part 4, we looked at an example of a company that earned a steadily declining return on the capital invested in its business. At the end of year 7, the company had after-tax operating earnings of $298.60 and was barely beating its cost of capital. By this time, the company had $1,791.60 in equity capital and $2,090.20 in debt (together, they equal invested capital at year-end).
If investors only considered the cost of debt, then it would look like the company was adding value to the capital at its disposal because earnings before interest and taxes in year 7 would be $459.38, much higher than the cost of debt with average debt of $1,791.61 (at 10%) in use in year 7. With that debt load, the company's interest expense would be $179.16 in year 7, giving the company interest coverage of 2.56 times, well within the comfort zone. After a tax savings of $62.71 (35% of interest expense, which is to say, the company's tax rate times its interest expense) that the company receives from using debt rather than equity, the cost of debt capital is $116.45.
However, even though the cost of equity does not show up on a company's income statement, it is not free. Investors expect a rate of return on equity that is in line with the S&P 500 and that also takes into account the specific risks of the company in question. In this case, we have a company that has an average debt-to-equity ratio of 109% in the year 7 and may also be operating in a slower-growth industry with poor economics to begin with. In that case, we would demand a rate of return on equity of about 1.2 times the S&P 500's historical return to compensate for the extra risk. That means that the equity being used by this business will cost it 13.2%. A lower return on equity will hurt the valuation of the company's equity and ultimately the multiple the market will pay for all the capital invested in the business as well as its earnings and cash flow.
Over the course of the year, the example company has $1,642.30 of equity in use. At 13.2% (the company gets no tax savings on this, since earnings attributable to equity are taxable), the cost of equity in use over the course of the year is $216.78. Combined with the after-tax cost of debt, the company's total cost of capital is $333.23, far less than the company's return on invested capital. The proof of this is found in calculating the company's weighted average cost of capital on a percentage basis. Average capital in use over the course of the year equals $3,433.90. Average equity amounts to 47.826% of average invested capital and average debt amounts to 52.17% of average capital. Therefore, the 47.826% of the capital costs 13.2% and the other 52.17% of the capital costs 6.5%, both after tax. To work out the weighted average cost of capital (WACC), multiply 0.47826 by 0.132 and add that to the product of [0.5217 x 0.065]. That equals 0.097041, or 9.7041%. Multiplying WACC by average total capital in use throughout the year, the cost of capital for the company was $333.23.
In this case, the company should trade below the value of its capital because it will continue to destroy value. If the enterprise were priced at one times invested capital, the equity value of the company would be equal to invested capital minus net debt, which puts equity value at $1,791.59. Over the course of six years, the stock of the company has appreciated by 79.2%, or 10.2% annually. At the end of the period, the company's price/earnings ratio has shot up to 21.3, which doesn't seem intuitive with net income being so heavily weighed down by net interest expense. However, at this point, investors are paying for a pile of capital and potential earnings and not so much the current earnings. As the company stands at the moment, it will sap away all shareholders' equity and its creditors will take control eventually.
Rather than acting as a stand-alone conception of how well a company is operating, ROIC should be looked at in relation to the company's cost of capital. Companies such as Coca-Cola <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KO)") else Response.Write("(NYSE: KO)") end if %> have operated on this system, called Economic Value Added, or EVA, for a number of years (as have leveraged buyout financiers). The philosophy doesn't make these companies successful -- it's the implementation of it that makes a difference. Not all successful companies operate based on EVA, either. Some managements think in this way to begin with. However, the readers should know that some of the biggest generators of shareholder value over the last two decades have embraced this philosophy. The company in our example would have stopped growing at a certain point to preserve shareholder value, forgoing growth for growth's sake.
At a certain point, as we see in our example, more of the value of the enterprise goes to its creditors than to its shareholders. When ROIC starts to drop (return on marginal invested capital is a good early warning sign of this), investors should pay attention. It can signal anything from a momentary blip in the company's progress to a decay in industry or company fundamentals. Successful companies in more mature industries (the characteristics defining success for companies in hypergrowth industries are much different) generate ROIC above and beyond their cost of capital -- in fact, this is one reason why the S&P 500 is priced the way it is and why it has outperformed the small and mid-cap universes.
Companies in the S&P 500 are simply the creme de la creme of American business and show a better spread between their return on invested capital and the cost of capital they use. In addition, the very good S&P 500 companies are able maintain excellent returns on invested capital even as they increase invested capital year after year, while others rationalize their operations and sell off those units that can't generate the ROIC that they see elsewhere in their company. By dumping such operations, a company's earnings can shrink, but the valuation on the remaining earnings and capital invested in the business can increase so that the company is now worth more.
By looking at a company's financials from the standpoint of ROIC, an investor considers what's going on with both the income statement and the balance sheet. The various ratios that an investor considers (leverage, cash conversion cycle elements, margins, asset turnover) are brought together under the unified ROIC model. ROIC also allows an investor to look through the various accounting choices that a company can make to portray earnings. As most accounting regimes are rich in balance sheet accruals, ROIC is able to identify the real economic return a company generates. Those expenses that don't go into net income stay home on the balance sheet as part of the company's invested capital. So, what doesn't get considered in the numerator in ROIC has to be considered in the denominator.
Next: The Role of Cash in the Calculation
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