103 . Pascal Costantini.Pdf

Cash Return on Capital Invested With compliments To my family To Miko Cash Return on Capital Invested Ten Years of Investment Analysis with the CROCI Economic Profit Model Pascal Costantini AMSTERDAM • BOSTON • HEIDELBERG • LONDON • NEW YORK PARIS • SAN DIEGO • SAN FRANCISCO • SINGAPORE • SYDNEY • TOKYO Butterworth-Heinemann is an imprint of Elsevier Butterworth-Heinemann is an imprint of Elsevier Linacre House, Jordan Hill, Oxford OX2 8DP 30 Corporate Drive, Suite 400, Burlington, MA 01803, USA First edition 2006 Copyright © 2006 Elsevier Ltd. All rights reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without the prior written permission of the publisher Permissions may be sought directly from Elsevier’s Science & Technology Rights Department in Oxford, UK: phone (+44) (0) 1865 843830; fax (+44) (0) 1865 853333; email: [email protected]. Alternatively you can submit your request online by visiting the Elsevier web site at http://elsevier.com/locate/permissions, and selecting Obtaining permission to use Elsevier material Notice No responsibility is assumed by the publisher for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions or ideas contained in the material herein. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloguing in Publication Data A catalogue record for this book is available from the Library of Congress ISBN–13: 978-0-7506-6854-5 ISBN–10: 0-7506-6854-7 For information on all Butterworth-Heinemann publications visit our web site at http://books.elsevier.com Printed and bound in Great Britain 0607080910 10987654321 Working together to grow libraries in developing countries www.elsevier.com | www.bookaid.org | www.sabre.org Contents By way of introduction ix Acknowledgements xiii Part I What is Investment Analysis? 1 1 Investment, investors and financial analysis 3 An annoying question – inquisitive colleagues 3 Emotions in motion – tea-leaf reading? 4 The tools of investment – a (very) brief history of financial ratios 7 The people of investment – an unfair typology 9 The economic profit framework 12 The PE paradox – an introduction to behavioural finance 13 Coffee or beer? The issue of investment ‘styles’ 15 ‘Approximately and most of the time’ 18 2 The PE and the Equivalence principle: asset multiple and relative return 23 Cinderella’s slipper – a misunderstanding: economic versus actuarial 23 The PE ratio and its actuarial framework 24 The economic construction behind the PE ratio 28 The equivalence between asset multiple and relative return – the residual income model 29 Why would you use accounting numbers to fuel the EP model? 32 Empirical evidence of the Equivalence as an investment tool 34 Cost of capital and expected return 38 Is it for real? 40 Discounted cash-flow models and PE ratios – financial and investment analysis 42 The one-man band 43 Appendix: The multiple guises of the PE ratio 45 Part II Digging the Foundations: Reconstruction of Economic Data 51 3 Measuring the value of economic assets: the asset multiple 53 Tidying up a few loose ends 53 The debt problem: left and right, Cain and Abel, Miller and Modigliani 54 Liable: legally bound, under an obligation – beware of hidden liabilities 59 vi Contents The final calculation of the economic enterprise value 63 Inflation: apples and oranges, age and half-life, PPP 64 Invisibility and unaccountability: get a life, a non-smoker’s dream, the asset test 68 A certain Nobel Prize winner – not much for half a million – physical assets 73 4 The relative return 79 Keynes the speculator, Tobin the investor; jinxed in Pleasantville 79 Hotelling; a Stephen Hawking definition of assets – straight line’s not so straight 82 Dealing with infinity – cash return on capital invested 88 The cost of capital: an implicit calculation – fading and failing 92 An empirical calculation with multiple uses 100 5 The price of growth 105 The stuff of dreams 105 CROCI and the Big Mac 106 Same earnings growth, different valuation 108 Do you think what they think? 112 Growth matters sometimes – some disturbing news for growth managers 113 The third dimension – the Market Horn of Plenty 116 Part III Drawing Up the Plans: Analysis of Economic Profits 123 6 The fundamental analysis of economic characteristics 125 The storytellers – fundamental and investment analysis – the special case of financial groups 125 Missing something? The right chemistry 127 Three CROCI patterns: a typology of corporate behaviour 130 Asset growth – another insight into corporate behaviour 143 Everything and nothing 149 7 Investment analysis 151 Corporate anatomy: is a super-company always a super-investment? 151 I want to fly – the madness of crowds 153 A suspicion of rational causality: beacon in the dark 156 Practicalities of the asset multiple range 157 Actual and implied economic profits 162 The importance of lamp posts: General Electric 163 Man, the eternal optimist 167 Contents vii Part IV Building the House: Implementation of an Economic Profit Model 171 8 Stock-picking with an economic model 173 The inescapable question – investing and stock-picking 173 The growth/return interplay: Takeda at ¥6080, 9 February 2001 174 The growth/return interplay: Colgate at $58.50, 24 October 2001 176 Unemotional investing: Carnival Corporation at $20.80, 24 October 2001 179 How to assess growth: eBay and Wal-Mart, 9 February 2001 180 The madness of crowds: Colt Telecom at £21.30, 7 November 2000 182 How to spot a takeover target: AT&T at $15, 8 September 2004 183 Beacon in the dark: Forest Laboratories at $36.90, March 2005 185 Distressed equity: Marks & Spencer at £1.98, 7 November 2000 187 Debt and equity: Ahold at E6.10, 25 April 2005 188 New kid on the block: Givaudan at CHF 457, 8 May 2001 190 Painful memories: ‘We’d rather own the bikes than the shares’ 192 9 Investing with an economic profit model 195 Prof. Markowitz’s legacy: investing with style 195 The price of risk: the equity risk premium 198 The pricing of the norm: this time, it’s different 201 Do you trust your brain? Paper models 204 Designing a systematic investment strategy 205 Three EP strategies on the test bench 208 The thing ‘works’! 217 By way of conclusion … 219 Further reading 225 Index 227 Risk is a function of volatility. These things are quantifiable. Long-Term Capital Management press spokesman By way of introduction A temporary confidence crisis In the early days of September 2005, this book was starting to take the shape that I had intended. There was still a lot of work to do, but the promise to hand over a manuscript of some use to the publisher in November was not necessarily going to turn out to be a monumental lie. As I was waiting for a flight in London’s City airport, I was spending my spare time at the bookshop and spotted a Peter Bernstein book that I had not read yet: Capital Ideas: The Improbable Origins of Modern Wall Street (John Wiley & Sons Inc., 2005). I enjoy reading Bernstein – an insightful commentator and theorist on financial markets – and I bought the book without a second thought. But I was so overwhelmed by the first page that I could scarcely get to the bottom. It started like this: The book could never have taken shape without the partici- pation of the people whose work it describes: Fischer Black, Eugene Fama, William Fouse, Hayne Leland, Harry Markowitz, John Mc Quown, Robert C. Merton, Merton Miller, Franco Modigliani, Barr Rosenberg, Mark Rubinstein, Paul Samuelson, Myron Scholes, William Sharpe, James Tobin, Jack Treynor, and James Vertin. I started to count how many Nobel Prize winners were mentioned. And it got worse: Each of them spent long periods of time with me in interviews, and most of them engaged in voluminous correspondence and telephone conversations as well. It was easy to realise that P. Bernstein was friends with them all: All of them read drafts of the chapters in which their work is discussed and gave me important criticisms and suggestions that enrich virtually every page of the book. And, finally, the paragraph finished with a bizarre: Most of them also provided their photographs. Even the joke seemed beyond me x By way of introduction At that point, my confidence level dropped to rock bottom. I mentally reviewed how many Nobel Prize winners in Economics I knew personally, which did not take that long OK, distinguished academics? Surely I could not count any of those I used to terrorise during my student years. I somehow recalled that the Head of Global Research at Deutsche Bank, incidentally my own boss, David Folkerts-Landau, used to be a Professor of Economics at Chicago. My friend and ex- colleague Jamil Baz, who kindly read the manuscript, is a Research Fellow at Oxford University, where he teaches financial economics, on top of being a proprietary trader. Of course, I was myself teaching a small postgraduate finance course at the University of Paris Dauphine. Perhaps there was a chance that some of the professors I had briefly met in the corridors there might acknowledge me, if asked. But, bar a few other acquaintances, I had to admit to myself that I was more likely to know a future Nobel Prize winner in Literature than in Economics. How, then, could I have the audacity to write something that would sit on the same shelf as the books of a guy who could call half a dozen of the very best brains in finance his friends? So I reread the manuscript, fully expecting to have to make an embarrassing call to Karen, my publisher.

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