The Power of Return on Capital: Driving Value Creation in Companies

Understanding Value Creation in Companies

When analyzing companies and their potential to create value for shareholders, two key factors stand out as critical drivers: return on invested capital and growth. While many investors focus primarily on growth rates, the importance of generating strong returns on capital is often underappreciated. As Tim Koller explains, companies that can achieve high returns on their investments are able to generate more cash flow and create significantly more value over time.

The Interplay Between Return on Capital and Growth

Koller highlights that for two companies growing at the same rate, the one with a higher return on capital will not have to invest as much to achieve that growth. This allows it to generate more free cash flow that can be returned to shareholders or reinvested for further growth. Over time, this compounding effect leads to much higher valuations for high-return businesses.

This dynamic helps explain why some slower-growing consumer packaged goods companies can command premium valuations despite modest top-line expansion. Their strong brand equity and high returns on capital allow them to convert a large portion of profits into distributable cash flow.

Common Misconceptions About Valuation Multiples

There's a widespread belief that a company's valuation multiple (like P/E ratio or EV/EBITDA) is primarily a function of its growth rate. However, Koller emphasizes that multiples are driven by both growth and return on capital. Two companies with similar growth trajectories can trade at very different multiples if one is able to generate substantially higher returns on its investments.

This misconception often leads investors to overlook excellent businesses that may not have eye-popping growth rates but consistently earn high returns on capital. Understanding the interplay between growth and returns is crucial for identifying undervalued companies.

Key Principles of Value Creation

Koller outlines some fundamental truths about how companies create value:

1. Companies thrive by creating real economic value for shareholders
2. Value is created by investing capital at rates of return exceeding the cost of capital
3. These principles apply across time periods and geographies

While these concepts may seem abstract at first, they form the foundation for understanding what drives long-term value creation and stock performance. Companies that consistently invest in projects and initiatives earning returns above their cost of capital will compound value for shareholders over time.

Focus on Real Value Creation

Koller emphasizes the importance of companies focusing on real, sustainable value creation rather than short-term financial engineering or accounting gimmicks. While it's possible to temporarily boost results through cost-cutting or accounting choices, eventually the underlying economics shine through.

Real value creation comes from:

• Investing in product development
• Building strong sales and marketing capabilities
• Developing competitive advantages
• Expanding into new markets
• Improving operational efficiency

Companies that neglect these areas in favor of short-term results often see their competitive position erode over time. The market may reward them initially, but eventually, the lack of investment catches up.

Challenges in Maintaining a Long-Term Focus

Despite the clear benefits of focusing on long-term value creation, many companies struggle to maintain this perspective. Koller identifies several reasons for this:

1. Pressure from short-term oriented investors and analysts
2. Compensation structures that incentivize near-term results
3. Boards that lack deep understanding of the business
4. Difficulty in evaluating long-term investments

Overcoming these challenges requires courage from management teams to ignore conventional wisdom at times and do what's right for the long-term health of the business. It also requires educating boards and key stakeholders on the company's strategy and investment thesis.

Focusing on the Right Investors

Koller advises companies to focus their efforts on long-term, intrinsic value-oriented investors rather than trying to please everyone. These sophisticated investors tend to have a better understanding of the company's strategy and are more supportive of investments that may pressure near-term results but drive long-term value.

By cultivating relationships with these investors and clearly communicating the company's long-term value creation strategy, management teams can build support for initiatives that may not pay off immediately but are crucial for sustained success.

Evaluating Management and Capital Allocation

For investors analyzing companies, assessing the quality of management and their capital allocation skills is crucial. Koller emphasizes looking for executives who:

1. Understand their business at a granular level
2. Are willing to make long-term investments even if they pressure near-term results
3. Allocate capital based on return potential rather than chasing growth for growth's sake
4. Communicate clearly about their strategy and rationale for major decisions

He notes that many companies lack this level of granular understanding, leading to suboptimal capital allocation. Executives may apply a one-size-fits-all approach rather than tailoring strategies to the needs of individual business units.

The Importance of Granularity

Koller argues that CEOs and CFOs need to manage their businesses at a granular level - ideally looking at 30-50 distinct units. This allows them to:

• Tailor strategies to the economics of each unit
• Identify high-potential areas for investment
• Spot underperforming units that need restructuring
• Allocate resources more effectively across the portfolio

Without this granular view, companies risk misallocating capital or applying strategies that work for some units but not others. This granular understanding also helps in communicating with investors about the company's strategy and performance drivers.

Determining Cost of Capital

While return on invested capital is crucial, it must be evaluated relative to a company's cost of capital. Koller provides some insights on estimating cost of capital:

• For most large companies, cost of capital falls in the 7-12% range
• Industry dynamics are the primary driver of a company's cost of capital
• Don't obsess over small changes in cost of capital estimates
• Focus more on the spread between ROIC and cost of capital

He notes that in recent years, artificially low interest rates have complicated cost of capital estimates. Their approach has been to use a long-term average real return on government bonds plus inflation to estimate the risk-free rate, rather than using current yields that may be distorted by central bank policies.

Reverse Engineering the Market

To validate their cost of capital estimates, Koller's team analyzes overall market valuations and implied returns. By modeling the typical growth rates and returns on equity for median companies, they can solve for the cost of equity implied by current valuations.

This approach has consistently shown a real cost of equity around 7% going back to the 1960s. Adding inflation brings the nominal cost to 9-9.5% for a typical company. This aligns with their estimates derived from other methods.

Evaluating Industries with Low Returns

Some industries, like automobiles, have struggled for years to earn adequate returns on capital. For companies in these challenging sectors, Koller advises:

1. Be very selective about new capital investments
2. Focus on improving returns in existing operations
3. Consider returning excess cash to shareholders if reinvestment opportunities are limited
4. Look for ways to differentiate and earn higher returns than competitors

He notes that even in tough industries, there are often companies that find ways to earn strong returns through superior execution or differentiated strategies. Investors should seek out these outperformers rather than avoiding entire sectors.

The "Milking" Strategy

For businesses in permanent decline, Koller mentions the concept of "milking" - extracting as much cash flow as possible while minimizing new investment. While this approach can make sense in some cases, he cautions against neglecting the core business entirely, as this can accelerate declines.

The key is being very selective about where to deploy capital, focusing only on the highest-return opportunities that can extend the life of the business. Any excess cash should be returned to shareholders.

US vs European Returns

Koller discusses the significant gap in stock market returns between the US and Europe over the past decade, with US stocks dramatically outperforming. He attributes this to several factors:

1. Higher returns on invested capital for US companies
2. Improving profit margins in the US
3. Faster growth rates for US businesses
4. US leadership in key sectors like technology and life sciences

While some investors expect this performance gap to mean-revert, Koller is skeptical this will happen quickly. He notes that the US maintains significant advantages in fostering innovation and new company formation that are likely to persist.

Looking Beyond Averages

Despite the overall return gap, Koller emphasizes that there are still many excellent European companies earning high returns. The averages are dragged down by a larger number of low-return businesses in Europe.

For investors, this means opportunities still exist in Europe, but more selective stock-picking is required. The best European companies in a given industry may still outperform the median US company.

Valuation in Uncertain Times

With heightened economic uncertainty and recession fears, many investors struggle with how to approach valuation. Koller offers several pieces of advice:

1. Focus on long-term fundamentals rather than near-term volatility
2. Consider how uncertainty affects specific businesses differently
3. Look for companies continuing to invest through downturns
4. Be wary of businesses "freezing" due to uncertainty

He notes that investment cycles for many businesses are longer than typical recessions, so companies shouldn't necessarily halt all investment due to near-term fears. The key is understanding how macroeconomic factors specifically impact each business.

Opportunities in Uncertainty

Periods of high uncertainty often create opportunities for long-term investors as the market becomes overly pessimistic on some companies. Koller suggests looking for:

• Businesses with strong competitive positions trading at discounts
• Companies continuing to invest in growth despite headwinds
• Industries with secular growth drivers that persist through cycles

By maintaining a long-term perspective and understanding company-specific factors, investors can find attractive opportunities even in challenging markets.

Preferred Valuation Metrics

When it comes to valuation multiples, Koller expresses a preference for enterprise value-based metrics over equity-based measures like P/E ratios. Specifically, he recommends:

• Enterprise Value / NOPAT (Net Operating Profit After Tax)
• Enterprise Value / EBITDA in some cases

The rationale is that these measures provide a cleaner look at core business performance and allow for better comparisons across companies with different capital structures or tax situations.

Why Not P/E?

Koller notes several issues with the popular P/E ratio:

• Influenced by non-operating items and one-time charges
• Affected by differences in capital structure
• Doesn't account for cash balances
• Can be distorted by accounting choices

He argues that more sophisticated investors and analysts have moved beyond P/E ratios, even if they remain popular in financial media.

The Case for EV/NOPAT

Enterprise Value to NOPAT is Koller's preferred metric because:

• It captures the full capital base of the business
• NOPAT provides a cleaner look at core profitability
• It accounts for differences in tax rates across companies
• Allows for better comparison of businesses with different asset intensities

He notes that EV/EBITDA can also be useful when comparing similar businesses, but EV/NOPAT provides more precision when evaluating companies with different profiles.

Key Takeaways for Investors

In synthesizing Koller's insights, several key lessons emerge for investors:

1. Look beyond growth rates to understand returns on invested capital
2. Focus on long-term value creation rather than short-term results
3. Seek out management teams with a granular understanding of their business
4. Be willing to invest in uncertainty if the long-term thesis is sound
5. Use appropriate valuation metrics that capture true business performance
6. Don't write off entire industries - seek out superior operators
7. Maintain a long-term perspective even in challenging markets

By incorporating these principles into their investment process, investors can better identify companies positioned to create significant value over time. While the market may not always immediately recognize this value creation, patient investors stand to benefit as strong returns on capital compound over many years.

Article created from: https://www.youtube.com/watch?v=LXbuuQtnkzw