Cash Return on Capital Invested: Ten Years of Investment Analysis with the CROCI Economic Profit Model

245 Pages·2006·1.76 MB·English

by  Pascal Costantini

Cash Return on Capital Invested
With compliments
(cid:2)(cid:2)(cid:2)
To my family
To Miko
Cash Return on Capital
Invested
Ten Years of Investment Analysis with
the CROCI Economic Profit Model
Pascal Costantini
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Contents
Bywayofintroduction 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 (cid:2)(cid:2)(cid:2) 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 (cid:2)(cid:2)(cid:2) 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
Bywayofconclusion… 219
Furtherreading 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,IwasspendingmysparetimeatthebookshopandspottedaPeterBernstein
book that I had not read yet: Capital Ideas: The Improbable Origins of Modern
WallStreet(JohnWiley&SonsInc.,2005).IenjoyreadingBernstein–aninsightful
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,
EugeneFama,WilliamFouse,HayneLeland,HarryMarkowitz,
John Mc Quown, Robert C. Merton, Merton Miller, Franco
Modigliani,BarrRosenberg,MarkRubinstein,PaulSamuelson,
MyronScholes,WilliamSharpe,JamesTobin,JackTreynor,and
James Vertin.
IstartedtocounthowmanyNobelPrizewinnerswerementioned.Anditgotworse:
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
discussedandgavemeimportantcriticismsandsuggestionsthat
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 (cid:2)(cid:2)(cid:2)