Tintin

In the 2009 President's Letter, Mark Leonard said that a focus on ROIC plus organic growth is a better way of looking at the true change in shareholder value over time because a VMS business can achieve incremental growth without corresponding incremental capital, as well as the fact that the intangibles acquired are not losing their value. I'm fine with that conceptually, but have a problem. To me it seems like using the ROIC plus growth overestimates the change in shareholder value because the organic growth is already captured in the ROIC. It's like having your cake and eating it. Let's go through the math in a very simple way and someone can hopefully point out where I'm going wrong. Imagine a VMS company produces $100 of NOPAT based on $500 of invested capital for a 20% ROIC. If we assume a 10% cost of capital and use a perpetuity formula, that means the company should be valued at $1,000. Let's assume that after implementing the Constellation playbook, the following year organic revenue grows by 10%. If margins are unchanged then NOPAT increases to $110 based on the same invested capital of $500 the prior year, for an improved ROIC of 22%. If the cost of capital remains 10%, and we assume that this growth is a one-time boost from following the 'pricing for value' playbook, then the company would be valued at $1,100 using a perpetuity formula once again. In this scenario, the value of the company has increased by 10%. But using the Constellation formula we arrive at 32%! ROIC (22%) plus organic growth (10%) = 32%. From my perspective, the increase in shareholder value appears to be more than adequately captured by looking at the growth of ROIC alone, which is 10% (the same difference that our PV formulas produced). After all, the increase in organic revenue growth is already captured by the higher numerator in year 2. Adding organic revenue growth to ROIC appears to significantly overstate the change in shareholder value, but that is what Mr Leonard appears to be suggesting. It's clear there must be a flaw in my thinking because of the reverence in which Mark Leonard's letters are held by a large number of people within the investment space. But I can't get my head around where I'm going wrong. Thanks.

Hi, I'm looking at a serial acquirer that reinvests all of its annual earnings back into M&A, but juices its returns on equity by using an equal amount of debt. This 50/50 strategy allows the company to double the pace of acquisitions. The conceptual issue that I have is how to model for the present value of the company's FUTURE debt that does not exist as of today. It seems to me that in order to arrive at a reasonable valuation, I cannot simply assume that all of the estimated future free cash flows will be coming back to the equity holders given that in order to generate those cash flows a significant amount of debt that is yet to be taken out will be needed. If I use the present value of EXISTING debt in my bridge from EV to equity, this won't take into account any of the FUTURE debt that the company will require in order to generate those growing cash flows, and my concern is that this will lead me to overvaluing the present value of the company's equity. Any direction in this area would be much appreciated. Thanks.

A lot of corporate finance tells us that looking at historic reinvestment rate * ROIC gives us a good indication of how much a company's earnings can grow by. In this context, I'm trying to look at different approaches to calculating a company's historic rate of reinvesting capital as a percentage of earnings. One of the formulas I've come across is; Net CapEx + Change in working capital / NOPAT. I am struggling to conceptualize why we need to add back depreciation in the above formula. To me, gross CapEx alone plus change in WC seems to be the most appropriate approach since it reflects the actual amount of cash investment that a firm has had to reinvest. In a simple example.... NOPAT - $100m Depreciation - $20m CapEx - $20m assume no change in WC According to the conventional formula, the company has not reinvested anything, which is clearly not the case. If it's reinvested the same amount of CapEx to cover its depreciating assets then while the company won't necessarily grow, that $20m CapEx is still a reinvestment required to sustain the existing level of business operations. To me, the reinvestment rate is 20%. The only way that I can see this formula working is that the reinvestment rate is implicitly defined solely as any capital that's reinvested into the business over and above the level of reinvestment required simply to maintain the existing business. But I haven't found any explicit definition to say that's the case, which is a bit confusing. By 'reinvestment rate' does this actually mean reinvestment 'over and above' investment in existing assets? In which case 'growth reinvestment rate' would perhaps be a more suitable title?

Thanks Cigarbutt for the reply. From what you are saying a company essentially pays the employee's personal taxes directly to the tax authorities on behalf of those employees, by withholding some of their stock options at the time of vesting. When looked at from this perspective, the company is just acting as an intermediary for its employees with the taxman, and those cash outflows actually represent the employees' personal liabilities rather than the company's liabilities. When I value a company that pays a ton of SBC, I always prefer to add it back to operating cash flows and treat it as if it were a genuine cash expense. That being the case, it makes little sense for me to also treat these net settlement of tax cash outflows as an operating expense for valuation purposes, since doing so would be 'double-counting' the same expense twice. The original SBC recorded as an annual expense on the Income Statement several years before vesting would already include the portion of tax expense that individual employees would subsequently have to pay out of their SBC awards. The conclusion therefore appears to be as follows - if investors add back SBC expense to operating cash flows, they should leave net settlement tax payments exactly where they are in financing outflows.

I would be grateful for any help in getting my head around this topic. In essence, I am currently looking at a company that has a considerable cash outflow relating to the above, and this cash outflow is shown under financing on the cash flow statement. Since these taxes relate to stock compensation, and stock compensation is essentially an operating expense, would it not also follow that such amounts are better understood as an operating cash flow item rather than a finance outflow? I am trying to get my head around the mechanics of the topic and want to understand if the tax payable is truly a finance outflow as the accounting rules seem to permit. Any help is greatly appreciated. Thanks.

The Nomad Letters are exceptional, value-compounding prose! I finished reading them about a month ago, and feel that I will still be coming back to them at least twice a year. They are that good.

Having been on my 'To Do' list for a long time, I finally got around to reading the Nomad Partnership letters over the weekend. Wow! I cannot remember the last time I derived so much value from something relative to the time required to read it. They can only be described as 'essential reading' for any investor with a long-term outlook. The concept of 'scale economics shared' is wonderfully intuitive, and has gotten my juices flowing again for ideas. I'd be grateful for any pointers on micro or mid-cap companies in any geography that are currently employing this business model. I feel the urge to start digging into some 10Ks! Thanks.