VALUE CREATION THINKING
% FUTURE PERFORMANCE SCORECARD
Managements, boards of directors, and investors should pay attention to the stock market’s assessment of their firms’ future profitability in order to judge the economic soundness of management's planned future investments. Business as usual is typically not strategically sound for firms priced with significant negative values for future investments, which means that current stock prices imply expected ROIs on future investments that are less than the firm’s cost of capital.
A quarterly-updated scorecard includes 1,000 industrial firms having the largest equity market capitalizations in the U.S. Financial and utility firms are excluded. The key metric is % Future—the estimated percentage of a firm’s market value due to investors’ perception of the viability of its future investments (see Chapter 6). The scorecard uses data supplied by Credit Suisse HOLT and ties into the life-cycle valuation model, which is a centerpiece of the book. HOLT CFROI and % Future data are also used for the annual Barron’s 500 company ranking and Forbes Ranking of the World’s Most Innovative Companies.
Click here for the performance scorecard that shows individual company data sorted high to low by % Future within industry sector. Click here for a table that aggregates company data to provide industry sector totals.
VALUE OF THE FIRM = VALUE OF EXISTING ASSETS + VALUE OF FUTURE INVESTMENTS
A popular mathematical treatment for the value of a firm’s existing assets is to calculate a normalized level of current earnings. This is then viewed as a perpetuity by assuming depreciation charges are automatically reinvested every year in the future to maintain today’s asset base. Hence, dividing this earnings by the cost of capital provides a present value for existing assets. This is a mathematical fiction based on a world of zero change. Investments in the future will actually be made in projects that offer the most economically promising opportunities as the firm adapts to a changing world. The perpetuity method incorrectly boosts the value of existing assets and therefore leads to an understatement of the value of the firm’s future investments.
With the HOLT CFROI life-cycle valuation model and global database, the future net cash receipts from a firm’s existing assets (see pp. 175 to 177 of my 1999 book, CFROI Valuation) wind down over the economic life of today’s asset base. The figure below illustrates the wind-down pattern.
Note that the net cash receipts include after-tax cash flows from operations adjusted for the estimated fade of CFROIs over time due to competition. Also included is the release of nondepreciating assets associated with today’s asset base. The present value of these net cash receipts is calculated using HOLT’s estimated cost of capital (discount rate). Arguably, this discount rate is superior to the conventional CAPM/Beta cost of capital as discussed in Chapter 7 of Value Creation Thinking.
Using the firm’s total market value as the sum of current equity market value plus the estimated market value of debt, then the implied value of future investments is the total firm value less the estimated value of existing assets. Consequently, % Future is as follows:
LIFE-CYCLE STAGES AND % FUTURE
A firm’s % Future is a gauge showing where investors believe a firm’s is positioned on its life cycle. Startup firms forecasted to earn high CFROIs with high reinvestment rates are accorded a very high % Future. As illustrated below, as a firm transitions over its life cycle, the % Future declines and turns negative when a firm is expected to earn less than the cost of capital on future investments.
INTERPRETING THE % FUTURE DATA
In Value Creation Thinking, the long-term cost of capital was referenced as 6 percent real (inflation adjusted). This was based on data for aggregate U.S. industrial CFROIs displayed in Figure 4.7 (shown below) in my 1999 book, CFROI Valuation.
In recent years, the aggregate CFROIs for U.S. industrial firms have risen substantially above the 6 percent benchmark. In addition, the current market-implied discount rate (see slide 47 of the PowerPoint presentation) is much lower than its long-term 6 percent real average due to monetary policy to lower interest rates. With a lower cost of capital more firms have CFROIs expected to be above the cost of capital. Hence, more firms currently have a positive % Future versus historical periods of higher cost of capital, such as the late 1970s and early 1980s.
In the Credit Suisse HOLT Performance Scorecard report, a given industry sector, such as consumer discretionary, shows firms ranked high to low on % Future. Under Armour, Tesla Motors, and Amazon are near the top of the consumer discretionary ranking, while JCPenney, General Motors, and Office Depot are near the bottom of the ranking.
The typical high % Future situation involves a firm whose past three-year median CFROI and estimated year-ahead CFROI (displayed in the scorecard report) are both high. Here, investors forecast a continuation of CFROIs well above the cost of capital. Consequently, the implied value of future investments is a large positive number. A different situation involves a firm that is forecast to make a significant transition in profitability, i.e., their future CFROIs are expected to substantially differ from near-term CFROIs. In such a situation, the % Future will seem inconsistent with near-term CFROIs. For example, Tesla Motors has earned very low CFROIs, yet investors expect huge gains in future profitability reflected in a high % Future. Kohl’s Corp. has a low % Future in spite of decent near-term CFROIs as investors expect conventional retail store operations, like Kohl’s, to face increasing competition in the future from firms such as Amazon.
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