Jeremy Johnson's  Instablog

Valuation is a challenging discipline because of the inherent difficulty of integrating large amounts of information in way that is useful for an investor.  For a model to be helpful, it should take relevant financial information and turn it into a set of relationships that are understandable and comparable across companies and industries.  Economic profit models are especially helpful in this regard because they bring to the forefront a company’s ability to generate returns on its investments thus probing deeper into a company than simply analyzing the cash it generates.  Such models can thereby help investors make judgments about a company’s ability to sustain current levels of cash generation and provide insight into how changes within a company and in the external environment can drive changes in corporate value.

Economic Profit

The following equation provides the foundation of an economic profit model:

FV =  (R - d) * NCI / d + NCI

Where:

FV = Firm value

NCI = Net capital invested

R = Rate of return

d = Discount rate (cost of capital)

The model defines firm value in terms of future economic profits discounted to perpetuity plus the value of a firm’s assets.  Economic profits are those above the required rate of return (the discount rate), highlighting one key differentiating feature of the model which is that it explicitly takes into account capital costs which is important in analyzing the value of growth.  There is no explicit growth component in the model; however, by adding some math to above equation, the value of growth can be explicitly integrated by calculating projected growth in net capital invested assuming a given rate of return, discounted back to the present.  One implication of the economic profit model is that growth only has value if the firm is earning in excess of the cost of capital.  Otherwise, there is only enough value in the growth to pay capital providers the minimum required return and no economic profits are generated.  For this reason, often times the value of growth is minimal.

Calculating the return on invested capital is not made easy by the current accounting paradigm which is heavily tilted toward loading the income statement with non-cash charges in an attempt to match the consumption of capital with the generation of profits.  The purpose of this paradigm is to have one number, namely net income that should convey all there is to know about a company’s profitability.  The problem is that calculating returns on investment becomes more difficult with this approach especially when compounded with other biases introduced by current accounting standards such as the accelerated nature of accounting depreciation.

One approach which attempts to solve this problem is to calculate an internal rate of return (IRR) for the entire company using gross assets as the initial investment, gross income as the regular periodic cash flow and asset life as the number of cash flows until asset exhaustion.  Using an IRR based on gross assets as opposed to a simple return based on net assets helps eliminate the problem of accounting distortions which tend to minimize net capital invested and makes for a more accurate view of a company’s ability to make investments at a given rate of return.  Calculating returns based on an IRR model also focuses investor attention on useful economic lives allowing them to make more intuitive adjustments for replacement costs.

Turning back the question of growth, the IRR can embed some growth assumptions into the valuation since the periodic income is assumed to be reinvested at the IRR rate.  The reinvestment of all income at the IRR can be an unrealistic assumption especially for companies with high returns on capital and limited ability to reinvest profits.  For this reason, it is important to adjust the reinvestment rate, producing what it termed a Modified IRR (MIRR).  For companies with returns around the cost of capital, the adjustment leads to little change in value, but scales higher as returns on capital increase.  In general, it is best to make growth assumptions as explicit as possible instead of letting the IRR calculation carry a large share of the value of growth.

Expense capitalization also embeds assumptions about growth.  If investments such as R&D increase, new profit must emerge in order for returns on invested capital to remain the same.  Initially, the impact of additional expenditures is limited but over time becomes greater as more years pass at the higher expenditure level.  If profit does not increase in the wake of greater expenditures, returns on capital will decrease warranting a lower value.

The ultimate implication of the model is that companies generating higher returns on invested capital should trade at higher multiples of invested capital.  In fact, there is a direct one-for-one relationship between the ratio of returns on capital versus cost of capital and the market value of invested capital so that if a company earns twice the cost of capital, its assets should be worth twice the invested value.

Accounting Adjustments

An advantage of any systematic valuation process is the consideration of a defined set of variables across all potential investments.  By relying on a set model to contextualize financial information, it forces an investor to consider the same set of variables across companies and reminds them not to leave any part of the analysis undone.  This is one aspect of making adjustments to financial statements – making sure all relevant information is found and considered no matter the precise technique or model used to integrate that information.

Once information has been identified it must be adjusted to better reflect economic reality rather than accounting rules.  All the adjustments made to financial statements have only a few key goals: First, to identify all capital providers and quantify their exposure; second, to identify all the capital employed in a company; and third to determine the age and remaining useful life of that capital.  Along the way certain other adjustments are necessary for the sake of consistency.  For example, if gross assets are the basis of calculating the return (which is done to better reflect all the capital used in the business), then income must be adjusted to a gross basis to remain comparable.  In this way, adjustments to income are done to match the balance sheet presentation of assets or liabilities and are not done for their own sake.

Typical specific adjustments made to financial statements include capitalizing expenses such as R&D, advertising and rental expenses, inflation adjusting existing assets, adjusting depreciation schedules to better reflect replacement costs and economic value, and the consolidation of equity-accounted investments to better capture the amount of capital employed in these ventures. Regarding the identification of liabilities everything from stock options, to pension plans to other financial obligations are identified in order to determine the full current trading value of the firm.  Although simplistic in theory, there is often a lack of disclosure in company’s financial statements which can make for a significant amount of guess work and financial reconstruction.

Interpreting the Results

In practice, valuation can only give investors a guide post as to the future level of a company’s total firm value.  An undervalued company can quickly become an overvalued company if financial results deteriorate rapidly.  In 2007, building products companies capitalized with debt at three times gross cash flows were threatened with bankruptcy two years later due to a collapse in demand for their products.  In the public markets many historical examples exist of companies that are seemingly cheap -- even taking account of all the economic profit adjustments -- that turn out to be fairly valued or overvalued as financial results underperform historical trends. 

For this reason, a valuation cannot replace a strategic assessment of a company’s position; however, a valuation can be a useful tool to help make a strategic assessment of a company.  The most important aspect of this assessment is looking at returns on invested capital in the context of a company’s life cycle.  Companies with high returns on capital are more apt to experience competitive threats since other companies will be incentivized to enter their businesses.  Companies with returns on capital around the cost of capital are more likely to sustain their performance absent large changes in the macro environment.  Finally, companies earning below the cost of capital should be expected over time to improve their performance if the industry they operate in is not threatened with extinction and after a potentially painful restructuring. 

Investors can also use a model to determine where a disconnect in value lies.  If a company is undervalued based on run-rate profits, then there is little need to discuss what growth prospects are embedded in the market value because the answer is none.  Instead of focusing on whether the company can grow, an investor can turn their attention to whether the company can maintain its position.  The takeaway is that each company will have an individual strategic situation that must be analyzed, but an economic profit model can help investors with that task.

The Economy

Even a perfect valuation cannot protect investors from a recession which will impact the valuations of the vast majority of companies regardless of whether a company was overvalued or undervalued before a recession or whether a company’s profit is marginally or seriously impacted by the effects of a recession.  A valuation can alert investors to companies whose valuations make them more susceptible to larger falls in value.  Economic profit models cannot ring fence investors from the impact of a recession, and those owning equities should expect that recessions will lower valuations on all companies regardless of valuation. 

Further Reading

For those wanting to know more about economic profit models, I suggest taking a look at the following books:

Costantini, P. (2006). Cash Return on Capital Invested. Burlington: Elsevier.

Fabozzi, F. J., & Grant, J. L. (2000). Value-Based Metrics: Foundations and Practice. New Hope: Frank J. Fabozzi Associates.

Madden, B. (1999). CFROI Valuation: A Total System Approach to Valuing the Firm. Woburn: Butterworth-Heinemann.

Viebig, J., Poddig, T., & Varmaz, A. (2008). Equity Valuation: Model from Leading Investment Banks. Chicester: John Wiley & Sons.

Young, S. D., & O'Byrne, S. F. (2001). EVA and Value Based Management: A Practical Guide to Implementation. New York: McGraw Hill.