By way of background, my early research at Callard, Madden & Associates led to the development of the CFROI (cash-flow-return-on-investment) life-cycle valuation framework and this was documented in my 1999 book, CFROI Valuation, and further expanded with my 2016 book, Value Creation Thinking. The original goal was to implement a total system approach to valuation in which the estimation of the investors' discount rate was dependent upon the procedures used to forecast firms' net cash receipt streams. Key implementation principles included: (1) the use of economic returns (CFROIs) and reinvestment rates (life-cycle variables) to forecast firms' future net cash receipts, (2) all data inflation adjusted (real) and CFROIs adjusted for myriad accounting biases, (3) forward-looking, market-derived investors' discount rate based on a monitored universe of companies, (4) investor expectations decoded from current stock prices and expressed as future CFROIs and reinvestment rates.
This was a major effort and was well received by large money management organizations who were aware of the pitfalls of using unadjusted accounting data and the lack of comparability across time, across companies, and across national borders. The work was continued by HOLT Value Associates, which was acquired by Credit Suisse in 2002. Today, the Credit Suisse HOLT global database covers 20,000 companies and is a part of the investment process at many money management organizations worldwide.
How can this research program benefit individual investors? Duplicating the technical database adjustments and extensive valuation calculations is not feasible. I suggest you do what I do in analyzing companies with a life-cycle thinking template. The core idea is to pinpoint where a firm is on its life cycle and then scrutinize corporate communications to either confirm or disconfirm that management "gets it" as to what is needed to create significant shareholder value.
Displayed below are some top and bottom life-cycle performers. This is not a buy and sell list since I have not addressed investor expectations embedded in current stock prices. This is a "warm up" to get you thinking about how companies change over time and that what worked well in the past may not work so well in the future. The practical takeaway from this article is a link to current life-cycle data on 1,000 companies posted at ValueCreationThinking.com, which can help guide your analysis of potential buy/sell candidates. In future articles I plan to focus on individual companies and critique the information on company websites using the life-cycle framework in order to defend why I own certain companies and decided not to buy others.
Most large money management organizations use some version of the life-cycle framework for analyzing the investment potential of stocks. That is because it is rooted in the timeless principles of skill and competition that interact to determine long-term corporate performance, and ultimately, shareholder returns. Investors can improve their stock selection process by adopting this framework in two steps. First, position a firm on the life cycle using data as explained below. Second, apply life-cycle thinking to quarterly earnings conference call transcripts and major corporate news announcements. The following figure illustrates the key life-cycle variables that drive firms' long-term financial performance.
The upper portion describes the life-cycle stages of a firm that begins with successful innovation as reflected in economic returns (returns on capital) well above the cost of capital. Ideally, a firm has big commercial opportunities so that high reinvestment rates are coupled to value-creating economic returns. Success attracts competitors who also want to earn above-average profitability. Then, over time, due to competition, economic returns fade toward the cost of capital and reinvestment rates fade to slower growth rates. Eventually, firms become mature and earn approximately the cost of capital such that a dollar of new investment is valued by investors at only a dollar. Too often, management complacency and strongly-held, but obsolete, assumptions about value creation lead to bureaucratic inefficiencies and poor resource allocation decisions. The result is a failing business model and the need to restructure/downsize to avoid bankruptcy.
The lower portion of the figure plots a unique performance metric over time-% Future. A firm's % Future helps identify where a firm is positioned in its life cycle. Using the firm's total market value as the sum of current equity market value plus debt, the implied value of future investments is the total firm value less the estimated value of existing assets. The value of future investments is then expressed as a percentage of the firm's total market value. Startup firms forecasted to earn high economic returns with high reinvestment rates are accorded a very high % Future. As a firm transitions over its life cycle, the % Future declines, as seen above. Mature firms expected to earn the cost of capital have an approximate zero % Future. Note that a dollar invested below the cost of capital will be worth less than a dollar. Hence, negative % Future is a signal that business as usual is unlikely to reward shareholders over the long term.
Top and Bottom Life-cycle Performers
The Credit Suisse HOLT global database contains three fine-tuned variables that pinpoint a firm's life-cycle position. The first variable is a firm's % Future. The second variable is the past three-year median CFROI (cash-flow-return-on-investment). The third variable is the estimated year-ahead CFROI. Note that HOLT's CFROI is a cash-based measure of economic return that is inflation adjusted and minimizes various accounting biases. Although less accurate than the HOLT data, a rough approximation to life-cycle position can be estimated using Price/Book ratios and returns on invested capital.
Click here for a display of the HOLT life-cycle variables for each of the largest 1,000 U.S. industrial firms. From this universe of firms, the top ranked and bottom ranked ten life-cycle performers with equity market values at least $10 billion are listed below. Top performers have the highest rankings for % Future compared to all firms combined with past and future CFROIs in the top 20% compared to industry peers and vice versa for bottom performers.
|Company||% Future||Past 3 year CFROI||Estimated +1 year CFROI|
|FleetCor Technologies (NYSE:FLT)||79%||48.6||61.8|
|Verisk Analytics (NASDAQ:VRSK)||78%||43.5||48.4|
Nielsen Holdings (NYSE:NLSN)
Roper Technologies (NYSE:ROP)
IMS Health Holdings (IMS)
|Company||% Future||Past 3 year CFROI||Estimated +1 year CFROI|
Devon Energy (NYSE:DVN)
Anadarko Petroleum (NYSE:APC)
Norfolk Southern (NYSE:NSC)
Barrick Gold (NYSE:ABX)
Royal Caribbean (NYSE:RCL)
The list of Top Performers supports the view that in the New Economy, intangible assets are the way to earn especially favorable economic returns. Top performers include firms that utilize software, intellectual capital of employees, and platforms that provide high value to customers. In contrast, the bottom performers are heavily weighted by tangible assets (commodity producers, railroads, and the like). Click here for lists of top and bottom performers that include smaller firms.
The more one gains experience with life-cycle thinking, the sharper one becomes in focusing on the most critical issues impacting future shareholder returns. Managements of value creators (left side of the figure) should make substantial reinvestments in their high-CFROI businesses and, in particular, build/acquire capabilities as needed in order to continue to deliver high value to customers in a changing world. Managements of mature firms should have profitability improvement as their primary goal, not expansion. Managements of value depleters (right side of the figure) should purge business-as-usual complacency, reevaluate the core assumptions about their business model, and make the tough decisions needed to restructure/downsize as necessary.
As a general rule, buy those firms in which you believe managements are making the right strategic decisions, given their firms' life-cycle positions, and have the ability to deliver operating results in excess of the current expectations implied in their stock prices. By pinpointing a firm's current position on the life cycle, an investor is better equipped to apply hard-nosed skepticism to management's strategy and resource allocation decisions. This is the path to better stock selection.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.