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Valuation return on capital

Valuation return on capital

In assessing the value of a company, the market tends to focus almost exclusively on the outlook for earnings growth. While obviously important, this ignores other variables that are equally relevant in determining whether a stock represents a good investment from both a quality and a valuation perspective.

As is the case for any investment, the value is of stock is derived from the future cash payments received by shareholders, in other words the dividends received by shareholders. A dividend based valuation uses 4 variables:

  1. The level of earnings – technically, the valuation requires an estimate of the earnings generated over the next year.
  2. Sustainable earnings growth
  3. The sustainable marginal return on capital
  4. The cost of capital – this is the annual return required by an investor for a given investment

In this report I will focus on the third point, the marginal return on capital.

To deliver earnings growth, a company needs to invest. This investment might be new production capacity, or funds for incremental working capital. It might also be capital for acquisitions. As is the case for an individual, the best kind of investment is the type that requires the lowest upfront outlay. For example, any rational investor would prefer a $10 investment that generates $5 a year of return than a $100 investment that also returns $5 a year. The same applies to a company.

A company has a finite amount of capital. It can either reinvest for growth or it can return surplus capital to shareholder in the form of dividends or share buy backs. The higher the return on capital achieved on growth projects, the lower the amount of capital required to be retained to fund a given rate of earnings growth. A lower amount of capital required to fund growth leaves a greater amount of capital available to be returned to shareholders.

The ability to repeat the reinvestment in growth at a high rate of return is what defines an exceptional company due to the impact of compounding returns.

While not wanting to get bogged down in a finance theory lesson, a little mathematics is necessary. Below is the standard formula for valuing a company using the 4 variables.

Valuation return on capital

The numerator calculates the current sustainable annual dividend payment, while the denominator discounts the value of the growing dividend stream into perpetuity.

If we assume a 10% annual return is required by shareholders, we can calculate combinations of earnings growth and marginal return on capital that generate the same valuation. For example, the value of 5% a year growth at a 50% marginal return is that same as 6% growth at a 21.4% return and 7% growth at a 15.2% return.

The importance of the marginal return on valuation highlights why it is important to understand the source of a company’s future growth. Historical returns provide a guide, but not an answer. Organic earnings growth is generally higher return than earnings growth from acquisitions. This is because the net investment for acquisitions includes a payment for the value the previous owners generated above the value of the investment they made in the business themselves. This reflects a payment for goodwill, which reduces the marginal return on capital for the acquirer. Acquisition growth also tends to be higher risk as less is known about the investment as an outsider looking in as opposed to investing in your existing business.

Looking at Amcor as an example. The acquisition of Alcan in 2009 delivered strong earnings growth at a very high marginal return on capital through cost reductions. However with the majority of the benefits from that acquisition having been realised, and organic growth in the packaging industry remaining weak, future growth needs to be driven by acquisitions of small competitors. The company targets a 25% pre-tax return on acquisitions, but this is likely to represent a lower marginal rate of return than the company has generated over the last 5 years. While Amcor has remained disciplined in walking away from deals if the returns don’t meet its minimum requirements, rising asset prices invariably mean there are fewer available opportunities. This negatively impacts both the growth and marginal return outlook for the company relative to its recent history.

Another example is the impact of APRA’s decision to increase mortgage risk weightings for the major banks. Effectively, the major banks will be required to hold 55% more equity on mortgages from July 2016, diluting the return on equity for mortgages by 36%. Estimates of the dilution to bank ROEs resulting from increased capital requirements ranges from 1.5 to 2 percentage points, reducing both the earnings base as well as the future return on new mortgages written.

Therefore if the banks do not reprice products to increase profits, their stock values should not only fall due to the dilution of EPS from the capital raisings, but their PE ratios should also fall due to lower marginal return generation in future periods. If they raise prices to compensation for the increase equity capital, then their competitive position will be negatively impacted relative to other lenders in the market.

Roger Montgomery
Roger Montgomery

Roger shares his stock market insights at his Insights blog, Investors can also follow Roger on Facebook and watch media interviews at his YouTube channel. Grab your Second Edition copy of and learn how Roger Montgomery values the best stocks and buys them for less than they're worth. Grab the book now at special price!