Comparing Businesses Against Each Other
A dollar earned from a horseshoe company is the same as a dollar earned from a hospital.
Strip everything away from a business, its economic characteristics, its people. Cash in and cash out is all you are left with as a tool of comparison. At a business's most fundamental level, the difference between two companies will be the cash produced after additional reinvestment.
If business were a black box.
Consider two businesses A and B.
A & B generate the same earnings of $10 per year at 5% but they use/require a different level of base capital to produce these earnings.
A needs $100 in invested capital to produce $10
B needs $40 in invested capital to produce $10
Mathematically, A has an ROIC of 10% while B has a ROIC of 25%.
The result in the difference in base capital is principally a factor of how much money has to be reinvested back into the business. The resulting difference in the cash available to take out of the business is greater for B. The total available cash after reinvestment is defined as free cash flow (FCF).
A generates $5 FCF
B generates $8 FCF
The result of the differing free cash flow differences also finds its way into valuations. At a 10% discount rate assuming no growth for either company. A is worth significantly less than B.
What do we gain from this very simple explanation beyond making the obvious more clear? A few notions should follow.
- Return on beginning equity capital is the most appropriate single measure of managerial performance for a year.
- If a business consumes ever more capital, its returns will mirror the new amount of capital required.
- It will be difficult for a business to be worth more unless the required reinvestment of capital goes down over time. And as a result, the investor is likely to receive the same result unless they purchased at a major discount.
- The question should always be asked, how much capital reinvestment is required to obtain how much in earnings? Growth may come but at a material cost.
- How long can any favorable reinvestment pattern exist for a company? A survey of the top 200 companies that have increased earnings per share 15% a year for 10 years suggests it is not easy. Consider what business will do that over the next 20 years?