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The purpose of the capital markets is to allocate capital to its most efficient use. Research on economies around the world shows that functioning capital markets are positively correlated with economic growth. The more liquid and efficient the stock market is, the more the entire economy thrives.
Since capital markets exist to maximize allocative efficiency, we would expect the agents of capital—corporate executives—to focus on that goal. Yet, we know they do not. There are simply too many disincentives, such as huge bonuses tied to performance metrics that do not resemble shareholder value creation, including
- GAAP earnings
- Reported cash flow
- EBITDA and EV/EBITDA
- Return on equity
- Accounting book value
- Various other “non-GAAP” metrics
Not only do these metrics do a poor job of representing efficient capital allocation and value creation, they are also easily manipulated. A recent survey of CFO’s featured on MarketWatch showed 20% of companies misrepresent earnings by 10% or more, and, importantly, that Wall Street analysts do nothing about it.
It’s incredible that corporate executives and the market as a whole continue to depend on such flawed numbers when we already have a measure that is clearly linked with value creation: return on invested capital (ROIC). Figure 1 shows that ROIC has a clear and strong link to valuation for S&P 500 stocks.
[drizzle]Figure 1: ROIC Has The Largest Impact On Valuation
Sources: New Constructs, LLC and company filings.
This strength of this relationship is intuitive. If the purpose of capital markets is to promote the most efficient use of capital, it makes sense that the market would reward companies that earn the most profit per dollar of capital invested with the highest valuations.
Why Aren’t People Using ROIC?
The merits of linking stock valuation to shareholder value creation are so obvious that many believe it’s already what “analysts” and “smart investors” do. When I got to Wall Street, I was shocked at how much resistance there was to using value-based metrics like ROIC and Economic Value Added (EVA). After I left Wall Street to start New Constructs, the first reaction from investors that I called on was “why would anyone need research from New Constructs when that’s what the Wall Street already analysts do?”
The truth is, Wall Street has a lot of incentives not to deliver shareholder-value based research at scale. Most importantly, that business model wouldn’t pay as well as the status quo, which is pretty great for the big investment banks. They are able to sell simplistic and conflicted research because, even though the market as a whole values ROIC, the majority of investors don’t take the time to dig this deep.
In 2005, Brian Bushee at the Wharton School of Business looked at the behaviors of institutional investors. Here’s what he found.
- 61% are “Quasi-Indexers” that hold a large number of small stakes with low turnover, meaning they have little impact on market valuations.
- 31% are “Transients” that hold a large number of small stakes with high turnover, meaning they’re high volume of trading can have a big impact in the short-term, but doesn’t produce long-term gains because they’re going to sell any stake they take within a short time frame.
- 8% are “Dedicated”. These are the investors that do a significant amount of research before taking large stakes and holding them for a long time. Ultimately, it’s this small portion of investors that have the largest impact on long-term valuations.
Given the success and growth of the online brokers over the last decade, we think Bushee’s analysis, if applied to the entire investor population, would show even fewer “Dedicated” investors and far more Transients today. Nevertheless, looking at his numbers, it becomes clear how simplistic research proliferates.
Wall Street, the financial media and other purveyors of stock research want to serve the largest market, and that’s the quasi-indexers and transients who aren’t taking the time to do the deep research that an ROIC-based model requires.
Transients pile into companies that beat on quarterly earnings or meet certain technical indicators, giving the appearance that these measures drive stock prices even though these movements tend to be short-lived and have no basis in the underlying cash flows of the company. Since the transients turn around and sell their stakes quickly, the positive impact they have on the stock is soon cancelled out.
If technical research and superficial research works for 92% of investors, why provide anything else? Why do the hard work of really measuring value creation?
And it is hard work. Real shareholder value-based research is very difficult and time consuming, much more so than many people realize. Measuring shareholder value requires deep fundamental research that (1) translates reported accounting results into true cash flows and (2) quantifies the expectations for future cash flows that is embedded in stock valuations.
The first task requires deep expertise in both accounting and finance along with the fortitude to read 200+ page annual reports for every year of history you want to analyze. The second task requires additional expertise in valuation and the construction of large and complex models. Now, take into account that you have to do this work every single company you want to analyze or compare.
We are talking an almost impossible task. That is not to say that large firms have not tried. In the 1994 article from CFO Magazine, “Metric Wars”, several firms are featured for their unique consulting practices built around their proprietary measures of shareholder value creation. They failed for a variety of reason detailed here, but not because they had a bad idea. They had a great idea. They just lacked the technology to make that idea work.
As a result, investors have settled on simplistic metrics for evaluating executives or given up on trying to measure the process of corporate value creation by focusing solely on metrics such as Total Shareholder Return (TSR), GAAP earnings, non-GAAP earnings, top line revenue growth, or even just subscriber growth. As a result, we have a “tail wagging the dog” situation where investors link moves in the stock to how companies perform versus these simplistic metrics, and they totally ignore the true economics of the business. The more investors see stocks react in this way, the more they think the simplistic metrics drive the market, and the cycle spirals downward.
ROIC Is Hard
Calculating ROIC is hard. The formula for it seems simple, it’s just:
Unfortunately, accounting rules were originally designed for debt investors, not equity investors. Investors that want to calculate ROIC accurately have to make dozens of adjustments for each company. Financial statements are littered with one time items and non-operating income that have to be removed from reported earnings in order to get Net Operating Profit After Tax (NOPAT). Hidden off-balance sheet assets and write-downs have to be added back in order to calculate Invested Capital.