Financial Science and Art has based its research philosophy on the concept of Return on Capital.  This methodology has two main components:

PERFORMANCE MEASUREMENT

The crux of our methodology is a unique performance measurement called Cash Flow Internal Rate of Return (CFIRR).  CFIRR addresses many of the shortcomings of traditional performance measurements such as Return on Equity (ROE), Return on Assets (ROA) and Return on Invested Capital (ROIC).  In principle, CFIRR measures the return on capital but has distinct advantages over traditional return on capital measures.   Interestingly, the acronym RoC in our monthly “The RoC Report” stands for Return on Capital and was developed as a marketing term that was simpler and more effective than “The CFIRR Report.”  In our own reports, the term “return on capital,” or simply the term “return,” is used interchangeably with CFIRR.  However, in studying the details of the methodology it is important to make the distinction between CFIRR and traditional return on capital measures.

CFIRR should be viewed in context of capital growth and the cost of capital. We will discuss this further after we discuss how we calculate CFIRR.

CALCULATING CASH FLOW IRR

To calculate Cash Flow IRR, there are four separate components:

Figure 1: Cash Flow IRR as four components

1) Inflation Adjusted Gross Capital

The first step in calculating CFIRR is to determine the invested capital component.  Conceptually, invested capital is long-term debt + equity = assets – working capital.  This definition is sufficient when conceptualizing a company’s invested capital, however, there are other details to note.  Finance textbooks show two methods of calculating invested capital:

These two methods will always reconcile.

There are two distinct adjustments that are made to invested capital to calculate CFIRR compared to traditional definitions of invested capital.

i) The first adjustment to invested capital is to use GROSS investment - not the NET investment.  In other words, accumulated depreciation is added back to the net investment to get gross investment.  This is done to calculate the return on total capital contributed to the business.  The following example illustrates this application.

Suppose a landowner was considering building condos to be rented by the public.  The landowner would determine how much up front capital would be required to build the building. Then the landowner would estimate rates, including rental and occupancy, to estimate the total cash flow going forward.  He would then make a determination on whether or not to build based on the expected internal rate of return.  Suppose 10 years down the road the landowner wanted to determine if the decision to build had been favourable.  In post-mortem analysis, the landowner would look at actual rental rates and occupancy to calculate cash flow, and would still want to know the amount of his original investment, or gross investment.  He would not ask his accountant how much the building had depreciated to calculate the return.  It is not relevant.  In capital budgeting projects managers and analysts estimate the return on gross investment.  The return on gross investment is estimated in every finance situation.  It follows that the same should be done for publicly traded companies.  It is worth noting at this point that gross investment is used to determine the return on capital, but net investment will be used to determine the value of the company. (See Valuation section of this report)

ii) The second adjustment to invested capital is to use inflation adjusted gross investment.  This is done to get a real rate of return on capital and not a nominal rate of return on capital.  Since cash flow and earnings are in today’s dollars, it is necessary to adjust the gross investment into today’s dollars that is carried on the balance sheet at historical costs.  To clarify why this is important, consider a period of high inflation versus low inflation.  A company’s cash flow will be much higher during high inflationary periods compared to in low inflationary periods, but it is not attributable to real improvements in the business.

2) Cash Flow from Operations (CFO)

The second step in calculating CFIRR is to determine cash flow from operations.  Cash flow from operations is the after tax cash flow accruing to capital providers in a given year.  It’s the amount of money management can spend on new projects, pay dividends, etc.  By contrast, you can’t spend earnings, and therefore, cash flow is a better measure of value.  Since cash flow is not a GAAP term, there are variations on cash flow depending on the purpose. CFIRR uses:

It should be noted that CFO is a pre-interest measure of profitability to facilitate the comparison of firms with different degrees of leverage.  Using post-interest measures of profit negates this and makes leveraged firms appear less profitable.  Also, since interest is tax deductible, interest payments must be tax-effected when a post-tax measure of profits is used.  CFIRR adds back after-tax interest expense.  In other words, unleveraged firms do not get a tax shield from interest payments.  Therefore, to compare operating profitability between leveraged firms and unleveraged firms, after tax-interest should be added back to net income.  It follows that adding back after-tax non-operating income is also correct.   In contrast, it is correct to add back pre-tax depreciation and amortization as both leveraged and unleveraged firms would get a tax shield.

3) Asset Life

The third step in calculating CFIRR is to determine the average asset life.   This is the reverse of the straight-line depreciation equation.   That is, asset life equals depreciating assets divided by depreciation expense.  Specifically, CFIRR uses:

There is often confusion about the use of asset life in calculating a return on capital.  It can appear that CFIRR is predicting level cash flows for the life of assets, however we are discussing performance measurement.  At this point, CFIRR is simply calculating the rate of return subject to an asset life because different companies have different asset lives.  For example, steel companies have much longer asset lives than software companies. CFIRR addresses the issue of asset life variance.  This differentiates from traditional return on capital methodologies typically measured as ratios or effectively as perpetuities.  Perpetuities are level cash flows forever.

Consider the following example (salvage value is excluded to isolate the importance of asset life):

If asset life were not incorporated into CFIRR, Adobe would look like a much better company.  The ratio of CF / Invested Capital for Adobe is 26.2%, but since the asset life is only 6 years, the CFIRR return calculation is only 14%.  On the other hand, United Technologies has a longer asset life and the difference between CFIRR and CF/Invested Capital is minimal.

4) Salvage Value

The fourth and final step in calculating CFIRR is to determine the salvage value. The salvage value is simply the net working capital. Specifically, CFIRR uses:

Salvage value is the only adjustment that improves the return on capital compared to traditional return on capital measures.  It is an important adjustment for rapidly growing companies who often have large working capital balances just after large financings.  By considering the working capital as salvage value, the CFIRR gives a more accurate calculation for return on deployed capital.

CFIRR, CAPITAL GROWTH AND THE COST OF CAPITAL

CFIRR on its own is a useful measure, but it is also important to understand the relationship to capital growth and the cost of capital.

The value creation grid is an effective way of describing this relationship:

Figure 2: Valuation Grid

Destroying Value

Companies that are growing their capital while earning a CFIRR below the Cost of Capital (COC) are destroying value.  In general, the best strategy for companies in this quadrant is to sell off business units earning less than the COC.  Start-up companies that are building their business are the exception to this rule.  However, at some point companies must deliver a positive CFIRR – COC spread to maintain valuations.

Finding Value

Companies that are shrinking their capital while earning a CFIRR below the COC are finding value.  In theory, companies in this quadrant are selling their under-performing business units and keeping their performing units.

Limiting Value

Companies that are shrinking their capital while earning a CFIRR above the COC are limiting value.  In this quadrant, companies have good businesses but are not finding ways to make them grow.

Maximizing Value

Companies that are growing their capital while earning a CFIRR above the COC are maximizing value.  Companies in this quadrant are the best companies. They have good businesses and they keep growing profitably.

VALUATION

Theoretically, stocks trade at the present value of future cash flows accruing to shareholders.  However, future cash flows cannot be forecast with certainty.  If investors knew with certainty what future cash flows would be, they would pay exactly the same price for a stock. A similar example of this is a bond. The value of a bond is easy to calculate given the coupon rate, the prevailing interest rate and the face value (i.e. salvage value).  To calculate the value of the bond, all coupons payments and the face value are discounted to the present value using the prevailing interest rate to derive the price of the bond that every rational investor would pay.

A bond market only exists because of credit risk and fluctuating interest rates (variables that cannot be predicted with certainty).  In the absence of credit risk and fluctuating interest rates, we wouldn’t have a bond market. Stocks are no different than bonds, except that future cash flows for stocks have a greater degree of uncertainty.

Consider a bond with the following variables:

This bond can be valued in two ways:

Most people are familiar with Method 1 because it is straightforward.  Most people are also surprised that Method 2 provides the same answer. More importantly, Method 2 is more insightful because it shows “value added” over time.  We show Method 2 because it is the basis for how we value stocks.

Many of the same principles apply in valuing a stock as in valuing a bond.  The Face Value of the bond is similar to the Net Invested Capital in the company.  The Coupon of the bond is similar to the Cash Flow from Operations in the company. And, the Interest Charge is similar to a Capital Charge in the company. Stocks are more complicated because of growth and uncertainty that we will discuss later.

VALUATION BREAKDOWN

The figure below shows the breakdown of our methodology in valuing a company.

Figure 3:  Valuation Breakdown

1) Value of Inflation Adjusted Net Invested Capital

Recall that in performance measurement GROSS invested capital was the appropriate variable to use in calculating CFIRR.  However in valuation, it is appropriate to use NET invested capital.  At this point we want to know how much the company is worth.  If assets are old and depreciated we need to take this into account.  The line items included here are the same as performance measurement for inflation adjusted gross capital with the exception that it is after accumulated depreciation.   It is worth noting that the methodology separates out inflation adjusted net invested capital into 1a) working capital and 1b) fixed capital.

2) Value of Cash Flow Above/Below the Cost of Capital

This could also be called the “value added” and is the speculative portion of value.

Forecasts of CFIRR and capital growth will create value or destroy value.  If a forecast is a positive spread (i.e. CFIRR – Cost of Capital is positive), then value is created.  In this case, the higher the capital growth forecast, the higher the valuation creation.   If a forecast is a negative spread (i.e. CFIRR – Cost of Capital is negative) then value is destroyed.  In this case, the higher the capital growth forecast, the higher the value destruction.  If a forecast is a zero spread (i.e. CFIRR – Cost of Capital is zero), then growth does not affect value.

To help forecast CFIRR and growth, the methodology takes into account the life cycle of a company.

Figure 4: Company life cycle

The methodology uses the concept of company life cycle by using a “fade”.  The fade is separated into two phases:  Phase 1 fade is over the next 5 years of the company; Phase 2 fade is from year 6 to year 40.

In the default model, Phase 1 fade uses history to determine a straight-line fade.  CFIRR and growth will fade according to volatility and level.  If a company has a volatile history of CFIRR and capital growth, then the fade rate will be more pronounced.  Likewise, if a company is at a high level of CFIRR and growth, then the fade rate will be more pronounced.

In the default model, Phase 2 fade is an economic decay model, or reversion to the mean.  On average, companies only earn an after-tax real rate of return on capital of 6% and grow their capital at the long term GDP rate. Therefore, in Phase 2 fade, all companies fade to 6% CFIRR and 2% growth in year 40.

Analysts can override the default fades in both phases.  In Phase 1, analysts take into account factors including the competitive landscape, current events and new trends to develop a forecast.  In Phase 2, analysts take into account long-term sustainability such as brand strength and monopoly environments to develop a forecast.  In most cases, overriding Phase 1 is enough to develop a good case for the value of a stock.

At this point, we can calculate Enterprise Value by adding together 1) inflation adjusted net invested capital and 2) value of cash flow above/below the Cost of Capital.

3) Value of Debt

The value of debt (more accurately value of debt and equivalents) is calculated from the balance sheet as follows:

Other items that could be added to value of debt would be off balance sheet liabilities such as pending lawsuits and under-funded pensions.

4) Value of Equity

All the above calculations lead to the value of the equity.  The CFIRR and capital growth history lead to the CFIRR and capital growth forecasts, including the fade.  The forecast produces a stream of cash flows less the cost of capital that is discounted to the present value.  These discounted cash flows are added to the value of net invested capital to produce the total enterprise value.  Finally, the value of equity is calculated as the total enterprise value less the value of debt.

COST OF CAPITAL

This is the most contentious issue in finance and in our methodology.  Our cost of capital may seem simple (which is one of its advantages), but there are very good reasons for the methodology, which uses the 30-year Treasury bond rate.

The cost of capital, or discount rate, is used for two primary purposes:  1) to account for the time value of money; and, 2) to account for risk.

It is fair to say the time value of money is the same regardless of what company you are valuing.  The risk of each company varies, but it is better to model risk in the cash flows rather than in the cost of capital. To do this, we apply unique fade rates and conservative cash flow estimates for each company (as discussed) in order to perform rigorous scenario analyses to account for risk. This makes comparisons from company to company much easier.  In debating the value of companies, we would prefer to discuss fade rates and scenarios rather than the appropriate discount rate.

Sometimes the cost of equity can be lower than the cost of debt.  Companies typically raise equity when their stock price is high, resulting in minimal dilution for existing shareholders.  Companies raising capital can assess the cost of debt versus the cost of equity by comparing interest rate cost to dilution cost.  Furthermore, when companies are losing money, raising equity will dilute a loss (i.e. more shareholders sharing the pain).  On average, companies will raise money at or near the 30-year Treasury bond rate.

SUMMARY

Our methodology begins with historical performance measurement by calculating a company’s historical return on capital using the Cash Flow Internal Rate of Return (CFIRR), which reflects more accurately the true economic return on capital when compared to traditional measures.  At the same time, our methodology calculates the historical growth of invested capital.  After assessing a firm’s historical performance, our methodology calculates enterprise value by adding inflation adjusted net invested capital to an estimate of value added.  The value-added is estimated by forecasting CFIRR and capital growth over two phases.  Phase 1 is a forecast for 5 years, where a fade rate is applied to CFIRR and capital growth based on fade tables based on volatility and current level.  Phase 2 is a forecast for years 6 to 40, where a fade rate is applied using an economic decay or reversion to the mean. In the long-run, companies earn a CFIRR of 6% and grow capital at about 2%.  The present value of value-added is calculated using the cost of capital equal to the prevailing 30-year Treasury bond rate.  Risk is modeled in the cash flows and not in the cost of capital to make companies more comparable. Since companies raising capital have a choice between debt and equity, they will typically raise money at or near the 30-year Treasury bond rate.

The result is that QuickVALUATION provides investors and analysts a powerful tool to evaluate the ‘true’ value of the equity of virtually any publicly traded company in North America.  By comparing the ‘true’ or ‘intrinsic’ value of a company’s equity to it’s current stock price can help to identify excellent investment opportunities.