How Chief Financial Officers (CFOs) Earn Their Keep

How Chief Financial Officers (CFOs) Earn Their Keep

An informative piece written by the team at Liberty International Investment Management Inc.

My Liberty colleagues, Brett Girard CPA, CA and Thomas Zagrobelny, have written this article on how Chief Financial Officers (CFOs) earn their keep.

Essentially, if a company can earn more from its capital investments compared to how much it costs to earn that return, the firm should be profitable today, tomorrow and in the future. And if the returns are above average, then the odds for shareholders’ investment success improves.

And, now, to Brett’s and Thomas’ research:

Part of investing in a company for the long term is being able to determine if management is adept at consistently increasing shareholder value.

Our research has shown that free cash flow growth is a good proxy for increasing shareholder value. While measuring free cash flow growth is important, what if there was a tool to predict if cash flow will grow before it does? It turns out there is: Compare Return on Invested Capital (ROIC) to the Weighted Average Cost of Capital (WACC).

While the financial media has probably familiarized you with ratios like Price-to-Earnings, it’s unlikely you’ve heard of the comparison of ROIC to WACC. It’s a powerful tool used to evaluate the profitability of a given capital allocation or investment.

For example, imagine you have the opportunity to purchase a residential multiplex. The purchase price, or invested capital, is $1,000,000, annual rents are $100,000 and annual expenses are $30,000.

Based on this math, you would earn a net profit, or return, of $70,000 annually. A return of $70,000 on invested capital of $1,000,000 translates into a Return on Invested Capital, or ROIC, of 7% ($70,000/$1,000,000).

Now, 7% sounds good but we need more context – what if the interest rate at which the bank will lend us money is 10%? In that case, borrowing at 10% to invest at 7% does not sound attractive.

The borrowing rate is one component of the WACC. The other component of the WACC is the opportunity cost of the funds being invested. Opportunity cost can be thought of as the implied amount of return we are foregoing by making an investment.

Using the example above, you could buy the multiplex and earn 7% or you could invest in your neighbour’s bakery and earn 5% - by investing in the multiplex you forego the ability to invest in the bakery.

Returning to the original example of $1,000,000 invested to purchase the multiplex, if we are going to write a cheque for $200,000 and borrow the balance ($800,000) from the bank, our weighting of equity (our investment) to debt (bank borrowing) is 20% and 80%, respectively.

Let us then assume that the borrowing rate (cost of debt) is 3% and the opportunity cost (cost of equity is 5%). If we insert these figures into the formula below we can arrive at our Weighted Average Cost of Capital, or WACC.

In this example, the WACC of 3.4% allows us to make a binary decision as to whether we should invest in a project or not. If the expected return, or ROIC, is greater than 3.4%, we cover our cost of capital and will generate a return if we proceed with the investment, whereas if our ROIC is less than 3.4%, we will lose money on the investment and should not proceed.

This type of decision is made by CFOs and management teams every day. If a proposed investment, be it a new product line, purchasing a competitor, or buying a new piece of machinery shows an ROIC to WACC ratio of greater than 1, management can proceed, trusting that the returns generated will be accretive to shareholders.

Switching from the theory to a “real world” application, we have completed the analysis to the right on Rollins Inc., one of the largest pest control companies in the world and a stock that some of our clients own.

Looking at Rollins’s ROIC to WACC relative to their competitors demonstrates that the company is able to generate superior returns on invested capital. The chart below shows that for each $1 invested, Rollins is able to generate roughly $3 while its competitors make only $2. If this relationship holds over a decade, Rollins will be able to turn $1 into almost $20,000 while the competitors will turn that same $1 into about $500.

From the chart below, displaying Market Capitalization (the market value of the company), we can see how powerful a superior ROIC to WACC is to shareholder value.

Over the 10-year period from 2007 to 2017, Rollins earned a compound annual return of 20%, while its three competitors earned returns between 7% (Rentokil) and 11% (Ecolabs).

Things to consider about Return on Invested Capital (ROIC)

 → Asset intensity is a factor

The denominator of the ROIC calculation varies across industries. If you compare a brick and mortar business that has an asset-rich balance sheet, like TransCanada, to an asset-light service-based business with large amounts of goodwill and intangibles such as Rollins, the denominator in the equation will be substantially less for the latter, making ROIC look artificially high.

→ Overall industry growth is a factor

Young or fast-growing industries, on balance, will have higher ROIC expectations since there is new market share to acquire. This differs from mature and more stable industries where gains in market share are zero-sum and must be taken from a competitor.

For the companies in the young or fast-growing industries, this can be a double-edged sword, as high expectations lead to high stock valuations - any ‘slip-ups’ along the way can severely punish the firm’s stock price.

Things to consider about Weighted Average Cost of Capital (WACC)

→ Weighted Average Cost of Capital is based on risk.

The higher the risk of an investment, the higher the cost of capital that investors need to be compensated for taking more risk. All things equal, some of the drivers of WACC are as follows:

Generally, the larger a company, the more stable are its operations (think of Domino’s Pizza relative to the local pizza shop down the street). If you were lending money or making an investment, you would require a lower return from Domino’s, given the lower risk profile of the investment.

If the market perceives a company to have a sustainable competitive advantage, or economic moat in the parlance of Warren Buffett, then the expected risk of an investment will be lower relative to the competition. This reduces the required return investors expect, thereby lowering the cost of capital.

→ Consider the company’s capital structure, or how the assets are funded.

If a company is debt-free and then decides to issue debt, the likelihood of the debt being serviced is high. Compare this to a company that has a debt-to-equity ratio of 4-to-1, where for each dollar of equity invested they have borrowed $4.

The ability of the more in-debted, or highly-levered company to repay the debt is worse than the debt-free company as it already has a lot of debt on the books.

 → Industry cyclicality is a factor.

Certain industries involved in technology or industrials tend to be more cyclical than defensive industries like healthcare or financials. This riskiness factors into capital costs - companies in the latter, less risky categories can generally access funds from the capital markets at a lower rate.

→ The influence of interest rates

WACC is also influenced by interest rates. If you think back to the example of using bank financing to purchase an investment property, the mortgage rate will be dependant in part on what the underlying interest rate is. In practical terms, a spread is placed above the central bank reference rate leading to a percent for percent adjustment of WACC as interest rates fluctuate upwards and downwards.

When using research methods of both free-cash flow generation and combining it with an analysis of ROIC vs. WACC, investors can get a sense of what makes a quality company.

Companies that can illustrate these two qualities have the financial flexibility to compete effectively and make shareholders happy by consistently raising their dividends. This should, therefore, help improve their chances of investment success. That’s why it’s such an important metric in Liberty’s research efforts.

Resources,

https://www.libertyiim.com/wp-content/uploads/2018/10/Liberty-eNewsletterSep2018-FINAL.pdf