Warren Buffett’s $1 test and how to tell if a company is allocating its capital wisely

Buffett is essentially talking about return on invested capital.

• If a company invests $100 in something at the cost of capital of 10%, which in turn earns $7 in earnings forever, it would have a market value of only $70 ($7/10%), failing the $1 test. 
• Earnings of $11 or more would pass the test. 
• When companies make the decision to invest in M&A, CapEx or buybacks, they must make a conscious effort in evaluating if the potential returns would be meaningful and not capital destructive.

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By The Fifth Investor on October 9, 2017

Companies small or big must make capital allocation decisions on a frequent basis to maximize returns for shareholders. But only a few companies in the world have excellent capital allocators at their helms, most companies are run by excellent operators who alone are enough to generate meaningful profits, which shareholders would find forgiving enough.

Before a corporation invests in machinery, equipment, property or securities, like us they must make comparisons of returns that they’ll get when they allocate capital. These decisions are far more complex than personal decisions as they often involve a giant leap of faith into the unknown.

• How did Google calculate that Android would be a massive hit when they decided to allocate millions of R&D to it? 
• How did Google’s other failures not stop it from deciding to simply invest their monies in stocks or bonds or themselves (share buybacks)?

These decisions are of the highest risk, have a high potential for failure but if successful often give shareholders a multifold return. Although this may seem daunting to a budding retail investor, there are simpler ways to see if a company is allocating capital wisely: think top-down, think big.

1.  Capital expenditures –

• Is the company spending its cash meaningfully in CapEx? 
• What is the return on invested capital for the company? 
• Has the company managed to earn healthy returns on the incremental invested capital over the years? 
• What is their strategy? 
• In CapEx intensive industries, sometimes CapEx is spent not to expand and grow the business, but to just survive. That is often not an ideal situation as there’s no buffer should the market turn. 
• On the other hand, a CapEx-lite industry would see companies compete by spending in other areas that may not appear in the CapEx category.

2.  Share buybacks –

• Is the company spending its precious money buying back shares at all-time highs? 
• There’s a difference between mandated share buybacks and opportunistic buybacks. One is buying back shares no matter the price of the shares, and the latter is buying back shares only if the value of the company is worth more than its traded price (E.g. Berkshire will only execute buybacks when its P/B ratio is below 1.2).

3.  Mergers & acquisitions –

• Is the company acquiring businesses to bolt on to their existing operations? 
• How competent is the current management in the new industry where they’ve acquired a company? 
• How much of a premium have they paid to buy a company? 
• Does it even make sense? 
• A wasteful merger or acquisition can be deadly to your financial health.

4.  Cash –

• Is this company cash rich? 
• Does the management not know what to do with it? 
• What’s holding the company back? 
• Companies that are cash rich often trade at a discount, making them appear cheap, the most famous example would be Apple (although there may be tax reasons why Apple has stashed such a huge pile). 
• There’s a reason why companies like these appear cheap – the market deems the management to be incompetent in redeploying capital to earn a meaningful return for shareholders, and applies a discount to its shares.

Another way to look at it is the simple $1 test that Warren Buffett came up with in the 1980s:

“We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained.

Unrestricted earnings should be retained only where there is a reasonable prospect – backed preferably by historical evidence or, when appropriate by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.”

Buffett is essentially talking about return on invested capital. If a company invests $100 in something at the cost of capital of 10%, which in turn earns $7 in earnings forever, it would have a market value of only $70 ($7/10%), failing the $1 test. Earnings of $11 or more would pass the test. When companies make the decision to invest in M&A, CapEx or buybacks, they must make a conscious effort in evaluating if the potential returns would be meaningful and not capital destructive.

Companies that have heavy R&D spending as opposed to being CapEx-intensive like technology or pharmaceutical firms would require a more sophisticated understanding of their business models. That being said, the fundamentals of capital allocation are like the laws of physics – you can only spend so much cash on multiple failed ventures before the market realizes that you are incompetent.


The fifth perspective

Looking from the lens of an individual, companies are no different from investors at the very root – they’re in the business of making money. There will always be foolish investors and companies alike that waste their money in failed ventures or stupid decisions, and there will always be some rare, exceptional cases that earn outsized returns. Sticking to the basics in asking the most fundamental and simple questions can sometimes save your wealth and/or your company.



http://fifthperson.com/warren-buffetts-1-test-tell-company-allocating-capital-wisely/

Estimating the cost of capital

The weighted average cost of capital, WACC is the opportunity cost of choosing to invest in the assets generating the free cash flow (FCF) of that business as opposed to another business of similar risk.

For consistency, the estimate of the WACC should have the following properties:

1. it includes the opportunity cost of all investors,
2. it uses the appropriate market-based weights,
3. it includes related costs/benefits such as the interest tax shield,
4. it is computed after corporate taxes, 
5. it is based on the same expectations of inflation as used in the FCF forecasts, and 
6. the duration of the securities used in estimating the WACC equals the duration of the FCFs.

Given:
D/V = target weight in debt
E/V = target weight in equity
kd = required return of debt as source of capital
ke = required return of equity as source of capital
Tm = marginal tax rate

WACC = D/V * kd (1 - Tm) + E/V * ke



Cost of equity

The capital asset pricing model (CAPM) is a popular way to estimate the cost of equity.

It includes an estimate of

• the risk free rate, 
• beta, and 
• the market risk premium.

Estimated equity risk premium
= risk free rate + Beta x (market risk premium)
= risk free rate + Beta x (market risk - risk free rate)


Note:  there are alternatives to the CAPM such as the Fama-French three factor model and the arbitrage pricing theory.


Cost of debt

The after tax cost of debt requires

• an estimate of the required return on debt capital and 
• an estimate of the tax rate.

Other estimates include the weights in the target capital structure and, when relevant, the effects of debt equivalent and the effects of a complex capital structure

Conservation of Value and the Role of Risk. Increasing value through reducing the company's risk and its cost of capital.

Cash flow drives a firm's value creation.

Growth and ROIC generate cash flow.



Value creation

Companies create value:

• when they grow at returns on capital greater than their cost of capital or 
• when they increase their returns on capital.

Actions that don't increase cash flows over the long term will NOT create value, regardless of whether they improve earnings or otherwise make financial statements look stronger.

One Exception:  reducing the company's risks or its cost of capital can create firm's value

Actions the company takes to reduce a company's risk and therefore, its cost of capital.

There are different types of risk and it is important to explore how they enter into a company's valuation.

Only risk reductions that reduce a company's nondiversifiable risk will reduce its cost of capital.

Fundamental Principles of Firm's Value Creation

Value creation is determined by cash flows.

Cash flows are driven by 

• revenue growth and 
• return on invested capital (ROIC).

For any given level of revenue growth, increasing ROIC increases value.

However, increasing revenue growth does not always increases the firm's value.

• When ROIC is greater than the cost of capital, increasing growth increases the value of the firm.
• When the ROIC is less than the cost of capital, increasing growth decreases the firm's value.
• When ROIC equals the cost of capital, growth does not affect a firm's value.

Investors' Minimum Required Rates of Return, Cost of Debt and Cost of Equity

A company may raise capital by issuing

• debt or 
• equity, 

Both of which have associated costs.



Investors' Minimum Required Rates of Return

Investors' minimum required rates of return refer to the return they require for providing funds to the company.



Cost of Debts

A company's cost of debt is easy to estimate as it is reflected in the interest payments that the company is contractually obligated to make to debt holders.

For investors who provide debt capital to the company, their minimum required rate of return is the periodic interest rate they charge the company for using their funds.

All providers of debt capital receive the same interest rate.

Therefore, the company's cost of debt and investor's minimum required rate of return on debt are the same.



Cost of Equity

Estimating cost of equity is difficult because the company is not contractually obligated to make any payments to common shareholders.

For investors who provide equity capital tot he company, the future cash flows that they expect to receive are uncertain (in both timing and amount), so their minimum required rate of return must be estimated.

Further, each investor may have different expectations regarding future cash flows.

Therefore, the company's cost of equity may be different from investors' minimum required rate of return on equity.





Additional notes:

The company's cost of equity can be estimated using the dividend discount model (DDM) and capital asset pricing model (CAPM).

The costs of debt and equity are used to estimate a company's weighted average cost of capital (WACC), which represents the minimum required rate of return that the company must earn on its investments.

Capital Management in Personal Finance

A simple equation in finance describes your approach to capital management:

Assets = Debt + Equity

Everything you own was funded either by incurring debt or by expending your own resources.

Subtracting all your debt from the total value of your assets shows you how much equity (net wealth) you have accumulated.

The BALANCE of debt and equity you have used to fund the value of your assets is a critical portion of your financial management strategy, known as CAPITAL MANAGEMENT.



Cost of capital

Whether you use debt or equity to fund your asset ownership, there are COSTS OF DEBT and EQUITY involved, known collectively as COST OF CAPITAL.

The cost of debt refers to the amount of interest you will pay over the life of your debt.

Most people don't realise that there is also a cost associated with using your own resources to purchase assets, known as the "cost of equity".

"OPPORTUNITY COST" is the value of the next best option; so if you have the choice between purchasing furniture and keeping your money in a bank account, the opportunity cost of buying the furniture is equal to the amount of interest you would have earned by keeping your money in the account.

This makes most purchases far more expensive than people realise, since each purchase you make not only includes spending money, but also losing any earnings on that money if you hadn't spent it.




Effective capital management

Effective capital management requires you to assess the cheapest sources of both debt and equity being used to fund your assets, and also to find the proper balance of equity and debt so that you choose the cheaper of the two at any given point.

As you come to rely on one more than the other, its costs will start to increase; the more debt you have, the more lenders will start to charge you in interest rates as a result of the shift in your credit report.

If you rely more on equity, you will begin to pull assets which are more valuable, making debt cheaper compared to the money you would be losing by selling your investments.

The goal is to maintain the lowest cost of capital possible, using variations on the core equation:


Cost of capital 
= Cost of Equity + Cost of Debt
= [(E/A)*CE] + [(D/A)*CD]

E= The amount of equity you have
D= The amount of debt you have
A= The total value of your assets (D+E)
CE= The average cost of your equity (the money you would earn o the next best option)
CD= The average cost of your debt (the interest payments you will make)

E/A= weight of source of capital from equity
D/A= weight of source of capital from debt

You can assess whether your debt or equity is costing you more money from the above equation, to help you to determine the proper balance.

If these are not about equal, it is likely you could fund your assets more cheaply.




Are your assets generating returns more than the cost of capital?

Adding the cost of equity to the cost of debt gives you the total cost of capital.

The question remaining is whether your assets, on average, are generating MORE value than they are costing.

If yes, good for you.

If not, keep trying, because  right now you are losing money on your assets.

This equation only gives you a rough idea of your cost of capital, though.

The more precise you can be, even to the point of breaking down each source of debt and equity individually, the more accurate your calculation will be.

You are a lot better estimating the Cost of Capital without using fancy formulas

Estimate the Cost of Capital 

You have to estimate the cost of capital.  

First of all, the cost of equity will always be above the cost of the debt.  Secondly, the most expensive cost of equity is the type that venture capitalists have to pay.  If you read the VC magazines, they will tell you what returns they have to show on their old funds to raise money on their new funds.  These days that number is 15%.  Without doing any betas, you know the cost of equity is between 7% and 15% which is a lot better than the beta estimates.  

• Usually for the low risk firm with not a lot of debt, the cost of capital will be about 7% to 8%. 
• For a medium risk firm these days with reasonable debt, it will be about 9% to 10%.  
• For high risk firms, it will be 11% to 13%.

You are a lot better doing that than trying to estimate using fancy formulas.  So you get a cost of capital.

And the nice thing about not including the growth is that errors in the cost of capital are typically not that big. If you are 1% off in the WACC, you are 10% error in the valuation and that is not a killer error in valuation. 


Notes from video lecture by Prof Bruce Greenwald

http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

 

 

Cue:  7/11

Investment Decisions and Fundamentals of Value

@ 6.47 min
Managers should invest in real assets and should not be involved in investing in financial assets which the shareholders can do on their own.


What is a Valuable Investment Opportunity?

1. An investment worth more than it costs.
2. An investment with a return greater than its opportunity cost of capital.

Why does an asset have value?

1. An asset provides a return on investment in the form of future cash payments.
2. When we make an investment, we are buying a cash flow stream.
3. When we assess the value of an asset, we assess the value of its cash flow stream.

Asset valuation is the answer to the following question:

What is the PRESENT VALUE of a Future Cash Flow Stream?

@ 13 min

What determines the present value of a cash flow stream?

1. Magnitude
2. Timing
3. Risk

@ 15 min

Risk of the cash flow stream

Consider 2 cash flows streams A and B

A pays $100 for certain.

B may pay as much as $100 but may pay as little as $60.

Choice:  Choose A

We are risk adverse.  A SAFE dollar is worth more than a RISKY dollar.

@ 17 min

Time Value of Money

Time value of money is the rate of exchange between present dollars and future dollars established in the financial market.

Time value of money is reflected in the rates of return available to all investors in the financial markets.

@ 18.30

Risk and Return Relationship

Safe dollars are more valuable than risky dollars

Risk averse investors prefer safe investments.

How do you induce risk averse investors to take a risky investment?

Risky investments must promise higher returns to induce investors to undertake them.

In the financial markets, investments are priced so that the higher the risk, the higher the expected return.

Risky investment's rate of return reflects a risk premium that rewards investors for taking on the investment's risk.

Investment's opportunity cost of capital is the return forgone on an investment in the financial market of comparable risk.

Riskier investments have higher opportunity costs of capital.

Rate of Return = Time Value of Money + Risk Premium

Rate of Return = Risk Free Rate + Risk Premium

@ 21.30

Value of an asset:

1.  Forecast the magnitude and timing of the cash flow stream over its economic life.

2.  Assess the risk of the cash flow stream.

3.  Value the cash flow stream given its magnitude, timing, and risk at its opportunity cost of capital.

Market Value and Rate of Return

@ 23 min

The cash flow stream's value is determined by the amount of money needed today to recreate its magnitude, timing, and risk in the financial market at its opportunity cost of capital.

@ 24.50

What is the investment's opportunity cost of capital?

PV = FV / (1+r)

The value of an investment asset is the money needed today to recreate its future cash flow stream in the financial market at its opportunity cost of capital (r).

The value of an investment asset is the present value of its future cash flow stream.

How much is the asset worth, and how much does it cost?

• What is the value of the asset's future cash flow stream today, and how much does it cost?
• What is its PRESENT VALUE, and how much does it cost?
• What is the prevent value net of cost?
• What is its NET PRESENT VALUE?

NPV = PV of Investment - Cost

A valuable investment opportunity is worth more than it costs.

@ 31 min

If 

NPV > 0, investment is worth more than it costs

NPV < 0, investment costs more than it is worth.

NPV =0, investment costs as much as it is worth.

NPV is the absolute dollar change in wealth from the acceptance of an investment opportunity.

Look for investment opportunities in those with positive NPV projects.

What is a valuable investment opportunity?

1. An investment with a net present value greater than zero.
2. An investment with a return greater than its opportunity cost of capital.

Investment Decision Rules

1. Accept all investments with Net Present Values greater than Zero.
2. Accept all investments with rates of return greater than their opportunity costs of capital.

@ 34 min

Example using the Net Present Value Rule

NPV = PV - Cost 

> 0, therefore we accept the project.

@ 35 min

Example using the Rates of Return greater than their Opportunity Cost of Capital

Rate of Return = 20%.

Opportunity cost of capital = 12%.

Therefore, accept the project.

@ 36.50

You are considering an investment opportunity that costs $100,000 and promises to return 10%.

A comparable investment in the financial market returns 15%.

A bank offers to lend you $100,000 at 8% with no conditions.

Do you invest $100,000 in the investment opportunity?  NO.

Financing cost = 8%.

What is the investment's cost of capital? 15%.

The cost of capital is the return on comparable investments in the financial market, that is 15%.

The cost of capital is not the cost of raising the money to finance the investment.  That is a financing decision and not an investment decision.  

That return in the financial market is the standard against which other investment opportunities are evaluated.

The financing by the bank loan is irrelevant to the investment decision.

Investment decision and financing decision are separate and independent decisions.

First make the investment decision, after that, then make the financing decision.

Thanks for pointing this video out to me.
<  I found these very helpful : https://www.youtube.com/watch?v=ZtQKrPBz3XA https://www.youtube.com/watch?v=4q2Xcbrazhw on Financial Ratio Tutorial Anonymous on 4/7/13 >

Finance for Managers - Discounted Cash Flow Valuation Method

One big problem with the earnings-based methods just described is that they are based on historical performance - what happened last year.  And as the oft-heard saying goes, past performance is no assurance of future results.  If you were making an offer to buy a local small business, chances are that you'd base your offer on its ability to produce profits int he years ahead.   Likewise, if your company were hatching plans to acquire Amalgamated Hat Rack, it would be less interested in what Amalgamated earned int he past than in what it is likely to earn in the future under new management and as an integrated unit of your enterprise.

We can direct out earnings-based valuation toward the future by using a more sophisticated valuation method:  discounted cash flow (DCF).  The DCF valuation method is based on the same time-value-of-money concepts.  DCF determines value by calculating the present value of a business's future cash flows, including its terminal value.  Since those cash flows are available to both equity holders and debt holders, DCF can reflect the value of the enterprise as a whole or can be confined to the cash flows left available to shareholders.

For example, let's apply this method to your own company's valuation.of Amalgamated Hat Rack, using the following steps:

1.  The process should begin with Amalgamated's income statement, from which your company's financial experts would try to identify Amalgamated's current actual cash flow.  They would use EBITDA and make some adjustment for taxes and for changes in working capital.  Necessary capital expenditures, which are not visible on the income statement, reduce cash and must also be subtracted.

2.  Your analysts would then estimate future annual cash flows - a tricky business to be sure.

3.  Next, you would estimate the terminal value.  You can either continue your cash flow estimates for 20 to 30 years (a questionable endeavor), or you can arbitrarily pick a date at which you will sell the business, and then estimate what that sale would net ($4.3 million in year 4 of the analysis that follows).  That net figure after taxes will fall into the final year's cash flow.  Alternatively, you could use the following equation for determining the present value of a perpetual series of equal annual cash flows:

Present value = Cash Flow / Discount Rate

Using the figures in the illustration, we could assume that the final year's cash flow of $600 (thousand) will go on indefinitely (referred to as a perpetuity).  This amount, divided by the discount rate of 12 percent, would give you a present value of $5 million.

4.  Compute the present value of each year's cash flow.

5.  Total the present values to determine the value fo the enterprise as a whole.

We have illustrated these steps in a hypothetical valuation of Amalgamated Hat Rack, using a discount rate of 12 percent (table 10-2).  Our calculated value there is $4,380,100.  (Note that we've estimated that we'd sell the business to a new owner at the end of the fourth year, netting $4.3 million.)

In this illustration, we've conveniently ignored the many details that go into estimating future cash flows, determining the appropriate discount rate (in this case we've used the firm's cost of capital), and the terminal value of the business.  All are beyond the scope of this book - and all would be beyond your responsibility as a non-financial manager.  Such determinations are best left to the experts.  What's important for you is a general understanding of the discount cash flow method and its strength and weaknesses.

Table 10-2
Discounted Cash Flow Analysis of Amalgamated (12 Percent Discount Rate)

               Present Value                  Cash Flows
              (in $1,000, Rounded)       (in $1,000)

Year 1    446.5                               500
Year 2    418.5                               525
Year 3    398.7                               500
Year 4    381.6+2,734.8                 600+4,300

   Total    4,380.1



The strength of the method are numerous:

-  It recognises the time value of future cash flows.
-  It is future oriented, and estimates future cash flows in terms of what the new owner could achieve.
-  It accounts for the buyer's cost of capital.
-  It does not depend on comparisons with similar companies - which are bound to be different in various dimensions (e.g., earnings-based multiples).
-  It is based on real cash flows instead of accounting values.

The weakness of the method is that it assumes that future cash flows, including the terminal value, can be estimated with reasonable accuracy.

Buffett (1992): His thoughts on issuing shares.

His thoughts on issuing shares.  He concentrated most of his investments in companies where shareholder returns have greatly exceeded the cost of capital and where the entire need for future growth has been met by internal accruals.


Here are the investment wisdom Warren Buffett doled out through his 1992 letter to Berkshire Hathaway's shareholders.

Up front is a comment on the change in the number of shares outstanding of Berkshire Hathaway since its inception in 1964 and this we believe, is a very important message for investors who want to know how genuine wealth can be created. Investors these days are virtually fed on a diet of split and bonuses and new shares issuance, in stark contrast to the master's view on the topic. Laid out below are his comments on shares outstanding of Berkshire Hathaway and new shares issuance.

"Berkshire now has 1,152,547 shares outstanding. That compares, you will be interested to know, to 1,137,778 shares outstanding on October 1, 1964, the beginning of the fiscal year during which Buffett Partnership, Ltd. acquired control of the company."

"We have a firm policy about issuing shares of Berkshire, doing so only when we receive as much value as we give. Equal value, however, has not been easy to obtain, since we have always valued our shares highly. So be it: We wish to increase Berkshire's size only when doing that also increases the wealth of its owners."

"Those two objectives do not necessarily go hand-in-hand as an amusing but value-destroying experience in our past illustrates. On that occasion, we had a significant investment in a bank whose management was hell-bent on expansion. (Aren't they all?) When our bank wooed a smaller bank, its owner demanded a stock swap on a basis that valued the acquiree's net worth and earning power at over twice that of the acquirer's. Our management - visibly in heat - quickly capitulated. The owner of the acquiree then insisted on one other condition: "You must promise me," he said in effect, "that once our merger is done and I have become a major shareholder, you'll never again make a deal this dumb."

It is widely known and documented that Berkshire Hathaway boasts one of the best long-term track records among American corporations in increasing shareholder wealth. However, what is not widely known is the fact that during this nearly three decade long period (1964-1992), the total number of shares outstanding has increased by just over 1%! Put differently, the entire gains have come to the same set of shareholders assuming shares have not changed hands and that too by putting virtually nothing extra other than the original investment. Further, the company has not encouraged unwanted speculation by going in for a stock split or bonus issues, as these measures do nothing to improve the intrinsic values. They merely are tools in the hands of mostly dishonest managements who want to lure naïve investors by offering more shares but at a proportionately reduced price, thus leaving the overall equation unchanged.

How is it that Berkshire Hathaway has raked up returns that rank among the best but has needed very little by way of additional equity. The answer lies in the fact that the company has concentrated most of its investments in companies where shareholder returns have greatly exceeded the cost of capital and where the entire need for future growth has been met by internal accruals. Plus, the company has also made sure that it has made purchases at attractive enough prices. Clearly, investors could do themselves a world of good if they adhere to these basic principles and not get caught in companies, which consistently require additional equity for growth or which issue bonuses or stock-splits to artificially shore up the intrinsic value. For as the master says that even a dormant savings account can lead to higher returns if supplied with more money. The idea is to generate more than one can invest for future growth.

http://www.equitymaster.com/detail.asp?date=12/7/2007&story=3

GROWTH'S VALUE

GROWTH’S VALUE

Growth is not free.

Its price is the cost of capital necessary to support it.

Growth adds value only when the return on capital exceeds the cost of capital.

When capital costs equal capital returns, growth neither adds nor subtracts value, no matter how much or how little growth there is. The reason is intuitive: If an investor putting in new capital charges the same rate that capital generates, then there is no additional return available to prior investors.

Therefore:

1. If a company can attract capital at a cost lower than returns it generates, growth adds value.
   
2. If it attracts capital at a cost higher than what it generates, growth subtracts value.
   
3. If the cost of capital is the same as the return on capital, growth is neutral to value.

The only businesses in the first category are those possessing franchise characteristics. The only way to capture returns on capital greater than the cost of capital is to keep competitors out.

If competitors can get in, capital costs and returns will soon converge upon each other (or worse, capital costs will exceed capital returns).

To come full circle, growth is not free.


Also read:

1. Income Statement Value: The Earnings Payoff
2. Adjustments in Current Earnings figure
3. Avoid Pro Forma financial figures
4. Avoid Extrapolated Future Earnings Growth figures
5. Estimating Growth in Value Investing
6. Franchise Value
7. GROWTH'S VALUE
8. GROWTH'S VALUE (illustrations)