Questions About ROIC & Valuation
Recently, Arif and I had the pleasure of meeting with Raj, the very insightful author of the Scuttlebutt Investor blog. Scuttlebutt is a term used by the legendary investor Phil Fisher, who, along with Charlie Munger, was largely responsible for shifting Warren Buffett’s attention away from the “cigar butt” deep value investments favored by his mentor Benjamin Graham and towards high-quality companies. After our meeting, Raj sent us a handful of follow-up questions about our investment approach that we thought we’d answer here.
Since we started writing Intrinsic Investing we’ve gotten lots of emailed questions from professional and casual investors alike (feel free to contact us yourself), which we answer directly or sometimes work into our posts. We try to keep the content here accessible to a general audience while also trying to examine investing in a detailed and nuanced way. But due to the nature of these questions, this post will be geared more towards professional investors or anyone interested in the fine details of how we evaluate potential investments. All content in italics are questions from Raj.
I know that you generally look for businesses that generate high return on invested capital (ROIC). Would this lead you to a natural predisposition for asset light/software types of businesses? These will nearly always generate higher ROIC than an asset intensive or asset medium business like a railroad or manufacturing company.
High returns on invested capital come from one of two sources; 1) Large amounts of revenue generated for each dollar of invested capital, known as high “turns” of invested capital and/or 2) high levels of after-tax profits generated per dollar of revenue, known as high-profit margins. Turns x margin = ROIC (this is a rearrangement of the formula for ROIC we presented here). In order to generate high ROIC, a company must either have very high profit margins or need low levels of invested capital (ie. be “asset light”) or a combination of the two.
Because profit margins are bounded (pre-tax profit margins can’t exceed 100% and all companies pay some tax) it is difficult for a company to generate outstanding ROIC simply through a high profit margin. The far more common path is for a company to craft a business model that does not require them to invest too much new capital in order to grow. These asset-light companies are very prevalent in Ensemble Capital’s portfolio.
However, we do not restrict ourselves to buying asset-light companies. Some companies spend an enormous amount of money on capital expenditures (fixed assets such as factories, technology hardware, and property), but the nature of their business does not require them to carry much working capital (the difference between short term assets like inventory or accounts receivable and short-term liabilities like accounts payable and deferred revenue). In fact, some companies actually operate in a negative working capital condition which leads to them gathering cash faster than they need to pay it out causing cash to pile up on their balance sheet as they grow rather than them needing to invest cash into their balance sheet. So some companies can generate high ROIC even while spending a lot of money on fixed assets because their working capital needs are minimal or even negative.
Finally, while we do focus on high ROIC companies, what is most important to us is that a company has a strong set of competitive advantages that will allow them to protect and maintain a solid level of ROIC. First Republic, a bank that we recently profiled, would fit this mold as would the diamond retailer Tiffany. Because we believe these companies can generate solid and sustainable ROIC, we believe we can value them and therefore will consider them for investment. However, these companies deserve lower valuation multiples than high ROIC companies.
I would point out that asset-light companies are seen in many different industries, not just areas like software. For instance, our portfolio holding Landstar Systems is an asset-light business despite operating in the trucking industry. But their business model has them focused on logistics. By not owning the trucks themselves they are able to generate around $6 of revenue per year for each dollar of invested capital on their balance sheet (ie they generated invested capital turns of 6x).
For tech companies like Apple or Google, the ROIC is typically so high, based on the nature of the business and given the small denominator, that it almost seems not meaningful. Do you make adjustments to capitalize certain expenses in this case like marketing to make it more meaningful? Or is that just the nature of the beast; tech software and asset-light companies will have a higher ROIC given the nature of business?
The impact that higher ROIC has on valuation is not linear. A company growing 5% with a 20% ROIC will be able to distribute to shareholders $0.75 for each dollar of earnings vs a 10% ROIC company distributing $0.50. This means the improvement of ROIC from 10% to 20% increases cash flow per dollar of earnings by 50%. A 40% ROIC company will be able to distribute $0.875 or just a 17% improvement over the 20% ROIC business. So there is no need to adjust a company’s ROIC just because it is super high. As it gets higher and higher, it ceases to have much incremental impact on valuation.
We do frequently make adjustments to financial statements. Our goal is to understand the true cash economics of the business model. GAAP accounting is very helpful in this regard, but it is not the optimal way to understand cash economics. While capitalizing expenses that are expected to pay off in future years (such as some marketing expenses, research and development, etc) makes good theoretical sense, we’ve found that it is much simpler and just as accurate to instead base your terminal earnings multiple on a profit margin that assumes these sorts of expenses are at run rate levels once growth reaches its sustainable rate. In other words, rather than doing detailed capitalization accounting because you think 10% R&D spending is really “growth spending”, simply set R&D spending at the level you think is needed to drive long-term sustainable growth when you are setting your terminal value.
How do you calculate the denominator for ROIC? I think your post on ROIC didn’t delve into the specifics of the calculation of the denominator. But I think you might have said that you do not include goodwill. Help me understand this. The way I think about it ultimately all decisions of investment are buy or build decisions. If a company builds a new business, their ROIC is impacted to the downside by the investment in the new property, plant and equipment (PP&E) at market rates. However, if we exclude goodwill, then they are not being impacted to the downside for acquisitions. They are only being impacted by the book value increase in PP&E but not the market value they paid for said assets. Can you help reconcile this?
When calculating invested capital (the denominator for ROIC), we include all tangible balance sheet items involved in operating the business. This means we exclude liabilities related to debt as well as assets and liabilities that are non-operating (such as pension liabilities). In growing the business, these balance sheet items do not need to be invested in and thus are not part of invested capital (this isn’t to suggest they are irrelevant, just that they are not part of calculating ROIC).
The key to thinking about invested capital is realizing the whole value of this analysis is trying to understand how much cash the company will need to consume as it grows and how much will be available to pay out to shareholders. If a balance sheet item will not produce or consume cash as the company grows, it isn’t relevant to the calculation of ROIC.
What about goodwill? This is the item on the balance sheet that accounts for the amount a company has paid for past acquisitions that was in excess of the value of the acquisition targets’ book value (ie. the value on their balance sheet). Raj rightly points out that goodwill accounts for part of the cash a company paid for past acquisition so why would we exclude this amount in evaluating the returns on invested capital?
As mentioned above, the reason we are interested in ROIC is because of the way it can reveal how much cash a company can distribute to shareholders in the future. The value of a company in most cases is nothing more than the present value of the cash it can distribute, so ROIC is key to understanding intrinsic value. So long as your projections for a company’s future growth are not dependent on future acquisitions, that goodwill is an item on the balance sheet that will not consume cash as the company grows and therefore should be excluded from the denominator when calculating ROIC.
Now, if your intention is to judge the past capital allocation decisions of management, then including the money they spent on acquisitions is perfectly reasonable. But if you are trying to assess future cash generation, past M&A decisions are irrelevant. The exception to this is if you make an explicit assumption that the company will make acquisitions in the future. Then, of course, you must consider the cash they will use to complete these deals. We do not commonly invest in companies where explicit future M&A deals are part of our investment thesis. But we have written about the attractiveness of “platform companies” where acquisitions are part of the value creation story.
I know you look for businesses that are trading at a discount to intrinsic value. How do you think about the calculation of intrinsic value? Assuming you use a discounted cash flow, what discount rate do you use? Do you use the same discount rate across all businesses and then determine the margin of safety or adjust it dependent on the business?
The intrinsic value of a company is the present value of the cash the company can distribute to shareholders over time. This is also the intrinsic value of all financial assets. Sometimes people get lost in thinking about valuation and make it more complicated than it really is. But the whole point of investing is to turn money into more money and so the value of an investment is nothing more than the amount of money it will provide over time. This is why Charlie Munger has said, “All intelligent investing is value investing — acquiring more than you are paying for.” If you pay $2 for a dollar bill, you have no hope of being a successful investor. This isn’t to say that investors who buy growth companies (as we do) cannot be successful. It just means that successful investors must purchase investments for less than the present value of the cash they will create in the future; you must acquire more than you are paying for.
Since intrinsic value is the present value of future cash flows, the only theoretically accurate way to value a company is to use a discounted cash flow method. In practice, many investors use various valuation rules of thumb instead. But these approaches are just implicit, rather than explicit, ways to calculate a discounted cash flow.
At Ensemble Capital, we build an explicit five-year projection of cash flows and then capitalize (by assigning a terminal multiple to the final year cash flow) the cash flows beyond our explicit time horizon. This method projects the sum total of future cash flows that can be returned to shareholders and discounts them back to the present so we can evaluate the present value of the business.
Raj asks two very important questions: “What discount rate do you use? Do you use the same discount rate across all businesses?”
The discount rate is the rate of return that investors require to own the company. In calculating the value of a business that we intend to buy shares in, we don’t care at all what discount rate other investors might require or what the current market implied discount rate is. We only think about what rate we require.
This is a critical distinction from what is taught in most textbooks and how we believe many investors approach the discount rate. If your discount rate is based on a rate you think the market (other investors) thinks is appropriate, what you will end up calculating is the value that you might sell a company to other investors. This approach is a form of speculating. You are buying a stock based on how much you hope you can sell it to someone else for.
In assessing the intrinsic value of a company, we focus instead on how much value it has to us. Because we focus on analyzing high-quality, competitively advantaged businesses, we generally feel that we would view these companies as fairly valued if we earned a rate of return of approximately 9% per year. This is our required rate of return and the discount rate we use to discount future cash flows back to the present. Since we seek to make investments in stocks that are undervalued, we are seeking to earn returns in excess of our required rate.
We do use different discount rates for different companies. For the companies we focus on, our discount rate varies from 8% to 11%. All this means is that we think a company with a very stable, highly likely stream of future cash flows is fairly valued when it is priced to generate a lower rate of return (ie. 8%) than a company with a volatile, less predictable stream of future cash (ie. 11%). The more certain we are that we’ll receive a certain level of cash flows from a company, the lower the rate of return we require to own it. This is the reason why bonds earn lower returns than stocks. Their future cash flows are steady and predictable, leading investors to require much lower rates of return to consider them fairly valued than is generally required for a stock to be considered fairly valued.
So thanks to Raj for asking a great series of smart questions. Hopefully, this extended set of answers is useful to those readers who are interested in the nuances of our investment approach. In the long-run, your success as an investor is based on getting the big ideas right, not the minutia. But we also think that by thoroughly exploring your assumptions and the details of your investment philosophy, you force yourself to confront inconsistencies and come to a deeper understanding of what you believe.
Ensemble Capital’s clients own shares of Tiffany & Co (TIF), First Republic (FRC), Landstar (LSTR), Alphabet (GOOGL), and Apple (AAPL).
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