Negative Reinvestment Rates Causes and Consequences

The reinvestment rate for a firm can be negative if its depreciation exceeds its capital expenditures or if the working capital declines substantially during the course of the year. For most firms, this negative reinvestment rate will be a temporary phenomenon

5 This tends to work better than averaging the reinvestment rate over 5 years. The reinvestment rate tends to be much more volatile than the dollar values.

reflecting lumpy capital expenditures or volatile working capital. For these firms, the current year's reinvestment rate (which is negative) can be replaced with an average reinvestment rate over the last few years. (This is what we did for Embraer in the Illustration above.) For some firms, though, the negative reinvestment rate may be a reflection of the policies of the firms and how we deal with it will depend upon why the firm is embarking on this path:

• Firms that have over invested in capital equipment or working capital in the past may be able to live off past investment for a number of years, reinvesting little and generating higher cash flows for that period. If this is the case, we should not use the negative reinvestment rate in forecasts and estimate growth based upon improvements in return on capital. Once the firm has reached the point where it is efficiently using its resources, though, we should change the reinvestment rate to reflect industry averages.

• The more extreme scenario is a firm that has decided to liquidate itself over time, by not replacing assets as they become run down and by drawing down working capital. In this case, the expected growth should be estimated using the negative reinvestment rate. Not surprisingly, this will lead to a negative expected growth rate and declining earnings over time.

fundgrEB.xls: There is a dataset on the web that summarizes reinvestment rates| I and return on capital by industry group in the United States for the most recent quarter.

B. Positive and Changing Return on Capital Scenario

The analysis in the previous section is based upon the assumption that the return on capital remains stable over time. If the return on capital changes over time, the expected growth rate for the firm will have a second component, which will increase the growth rate if the return on capital increases and decrease the growth rate if the return on capital decreases.

Expected Growth Rate = (ROCt )(Reinvestment rate)+ ROCt - ROCt-1

For example, a firm that sees its return on capital improves from 10% to 11% while maintaining a reinvestment rate of 40% will have an expected growth rate of:

Expected Growth Rate = (0.11)(0.40)+ 01^ - ^ = 14.40%

In effect, the improvement in the return on capital increases the earnings on existing assets and this improvement translates into an additional growth of 10% for the firm.

Marginal and Average Returns on Capital

So far, you have looked at the return on capital as the measure that determines return. In reality, however, there are two measures of returns on capital. One is the return earned by firm collectively on all of its investments, which you define as the average return on capital. The other is the return earned by a firm on just the new investments it makes in a year, which is the marginal return on capital.

Changes in the marginal return on capital do not create a second-order effect and the value of the firm is a product of the marginal return on capital and the reinvestment rate. Changes in the average return on capital, however, will result in the additional impact on growth chronicled above.

Candidates for Changing Average Return on Capital

What types of firms are likely to see their return on capital change over time? One category would include firms with poor returns on capital that improve their operating efficiency and margins, and consequently their return on capital. In these firms, the expected growth rate will be much higher than the product of the reinvestment rate and the return on capital. In fact, since the return on capital on these firms is usually low before the turn-around, small changes in the return on capital translate into big changes in the growth rate. Thus, an increase in the return on capital on existing assets of 1% to 2% doubles the earnings (resulting in a growth rate of 100%).

The other category would include firms that have very high returns on capital on their existing investments but are likely to see these returns slip as competition enters the business, not only on new investments but also on existing investments.

Illustration 11.12: Estimating Expected Growth with Changing Return on Capital: Titan

Cement and Motorola

In 2000, Titan Cement, a Greek cement company, reported operating income of

55,467 million drachmas on capital invested of 135,376 million drachmas. Using its effective tax rate of 24.5%, we estimate a return on capital for the firm of 30.94%:

135,376

Assume that the firm will see its return on capital drop on both its existing assets and its new investments to 29% next year and that its reinvestment rate will stay at 35%. The expected growth rate next year can be estimated.

In contrast, consider Motorola. The firm had a reinvestment rate of 52.99% and a return on capital of 12.18% in 1999. Assume that Motorola's return on capital will increase towards the industry average of 22.27%, as the firm sheds the residue of its ill-fated Iridium investment and returns to its roots. Assume that Motorola's return on capital will increase from 12.18% to 17.22% over the next 5 years6. For simplicity, also assume that the change occurs linearly over the next 5 years. The expected growth rate in operating income each year for the next 5 years can then be estimated.7 Expected Growth Rate

= (ROCcurrent )Reinvestment Rate^ )+

1 + in 5 years curren

V ROC current

V 0.1218 0

The improvement in return on capital over the next five years will result in a higher growth rate in operating earnings at Motorola over that period.

6 17.22% is exactly halfway between the current return on capital and the industry average of 22.27%.

7 You are allowing for a compounded growth rate over time. Thus, if earnings are expected to grow 25% over three years, you estimate the expected growth rate each year to be:

Expected Growth Rate each year = (1.25)1/3-1 = 0.0772.

chgrowth.xls: This spreadsheet allows you to estimate the expected growth rate in operating income for a firm where the return on capital is expected to change over time.

C. Negative Return on Capital Scenario

The third and most difficult scenario for estimating growth is when a firm is losing money and has a negative return on capital. Since the firm is losing money, the reinvestment rate is also likely to be negative. To estimate growth in these firms, you have to move up the income statement and first project growth in revenues. Next, you use the firm's expected operating margin in future years to estimate the operating income in those years. If the expected margin in future years is positive, the expected operating income will also turn positive, allowing us to apply traditional valuation approaches in valuing these firms. You also estimate how much the firm has to reinvest to generate revenue growth, by linking revenues to the capital invested in the firm.

Growth in Revenues

Many high growth firms, while reporting losses, also show large increases in revenues from period to period. The first step in forecasting cash flows is forecasting revenues in future years, usually by forecasting a growth rate in revenues each period. In making these estimates, there are five points to keep in mind.

• The rate of growth in revenues will decrease as the firm's revenues increase. Thus, a ten-fold increase in revenues is entirely feasible for a firm with revenues of $2 million but unlikely for a firm with revenues of $2 billion.

• Compounded growth rates in revenues over time can seem low, but appearances are deceptive. A compounded growth rate in revenues of 40% over ten years will result in a 40-fold increase in revenues over the period.

• While growth rates in revenues may be the mechanism that you use to forecast future revenues, you do have to keep track of the dollar revenues to ensure that they are reasonable, given the size of the overall market that the firm operates in. If the projected revenues for a firm ten years out would give it a 90% or 100% share (or greater) of the overall market in a competitive market place, you clearly should reassess the revenue growth rate.

• Assumptions about revenue growth and operating margins have to be internally consistent. Firms can post higher growth rates in revenues by adopting more aggressive pricing strategies but the higher revenue growth will then be accompanied by lower margins.

• In coming up with an estimate of revenue growth, you have to make a number of subjective judgments about the nature of competition, the capacity of the firm that you are valuing to handle the revenue growth and the marketing capabilities of the firm.

Illustration 11.12: Estimating Revenues at Commerce One

In earlier Illustrations, we had considered Commerce One, the B2B pioneer. In

Table 11.13, we forecast revenues for the firm for the next 10 years, as well as for

Ashford.com, an online jewelry and brand-name product retailer.

Table 11.13: Revenue Growth Rates and Revenues: Commerce One

Commerce One

Ashford.com

Expected Growth

Expected Growth

Year

Rate

Revenues

Rate

Revenues

Current

$402

$ 70.00

1

50.00%

$603

80.00%

$126.00

2

100.00%

$1,205

60.00%

$201.60

3

80.00%

$2,170

40.00%

$282.24

4

60.00%

$3,472

30.00%

$366.91

5

40.00%

$4,860

20.00%

$440.29

6

35.00%

$6,561

17.00%

$515.14

7

30.00%

$8,530

14.00%

$587.26

8

20.00%

$10,236

11.00%

$651.86

9

10.00%

$11,259

8.00%

$704.01

10

5.00%

$11,822

5.00%

$739.21

We based our estimates of growth for the firms in the initial years on the growth in revenues over the last year - we did lower the growth rate for Commerce One in the

We based our estimates of growth for the firms in the initial years on the growth in revenues over the last year - we did lower the growth rate for Commerce One in the first year because of the fact that the economy was weak at the time of the valuation and business spending had slowed.

As a check, we also examined how much the revenues at each of these firms would be in ten years relative to more mature companies in the sector now.

• We compared revenues at Commerce One in ten years to those of EDS - a leading provider of business services- today. EDS had revenues of $18.73 billion in 1999, which would make Commerce One a leading player in this sector but not by an overwhelming margin.

• Zale, which is the largest retailer of jewelry in the United States, had revenues of about $1.7 billion in 2000. Our projected growth rate for Ashford would give it revenues of $739 million.

Operating Margin Forecasts

Before considering how best to estimate the operating margins, let us begin with an assessment of where many high growth firms, early in the life cycle, stand when the valuation begins. They usually have low revenues and negative operating margins. If revenue growth translates low revenues into high revenues and operating margins stay negative, these firms will not only be worth nothing but are unlikely to survive. For firms to be valuable, the higher revenues eventually have to deliver positive earnings. In a valuation model, this translates into positive operating margins in the future. A key input in valuing a high growth firm then is the operating margin you would expect it to have as it matures.

In estimating this margin, you should begin by looking at the business that the firm is in. While many new firms claim to be pioneers in their businesses and some believe that they have no competitors, it is more likely that they are the first to find a new way of delivering a product or service that was delivered through other channels before. Thus, Amazon might have been one of the first firms to sell books online, but Barnes and Noble and Borders preceded them as book retailers. In fact, one can consider online retailers as logical successors to catalog retailers such as L.L. Bean or Lillian Vernon. Similarly, Yahoo! might have been one of the first (and most successful) internet portals but they are following the lead of newspapers that have used content and features to attract readers and used their readership to attract advertising. Using the average operating margin of competitors in the business may strike some as conservative. After all, they would point out, Amazon can hold less inventory than Borders and does not have the burden of carrying the operating leases that Barnes and Noble does (on its stores) and should, therefore, be more efficient about generating its revenues and subsequently earnings. This may be true but it is unlikely that the operating margins for internet retailers can be persistently higher than their brick-and-mortar counterparts. If they were, you would expect to see a migration of traditional retailers to online retailing and increased competition among online retailers on price and products driving the margin down.

While the margin for the business in which a firm operates provides a target value, there are still two other estimation issues that you need to confront. Given that the operating margins in the early stages of the life cycle are negative, you first have to consider how the margin will improve from current levels to the target values. Generally, the improvements in margins will be greatest in the earlier years (at least in percentage terms) and then taper off as the firm approaches maturity. The second issue is one that arises when talking about revenue growth. Firms may be able to post higher revenue growth with lower margins but the trade off has to be considered. While firms generally want both higher revenue growth and higher margin, the margin and revenue growth assumptions have to be consistent.

Illustration 11.13: Estimating Operating Margins

To estimate the operating margins for Commerce One, we begin by estimating the operating margins of other firms in the business services/software sector. In 2000, the average pre-tax operating margin for firms in this business was 16.36%. For Ashford.com, we will use the average pre-tax operating margin of jewelry and brand name product retailers, which is 10.86%.

We will assume that both Commerce One and Ashford.com will move toward their target margins, with greater marginal improvements8 in the earlier years and smaller

8 The margin each year is computed as follows: (Margin this year + Target margin)/2

ones in the later years. Table 11.14 summarizes the expected operating margins over time for both firms.

Table 11.14: Expected Operating Margins

Commerce One:

Ashford.com: Operating

Year

Margin

Margin

Current

-84.62%

-228.57%

1

-34.13%

-119.74%

2

-8.88%

-60.38%

3

3.74%

-28.00%

4

10.05%

-10.33%

5

13.20%

-0.70%

6

14.78%

4.55%

7

15.57%

7.42%

8

15.97%

8.98%

9

16.16%

9.84%

10

16.26%

10.30%

11

16.36%

10.86%

Since we estimated revenue growth in the last section and the margins in this one, we can now estimate the pre-tax operating income at each of the firms over the next 10 years in Table 11.15.

Table 11.15: Expected Operating Income

Commerce One

Ashford.com

Year

Revenues

Operating Margin

EBIT

Revenues

Operating Margin

EBIT

Current

$402

-84.62%

-$340

$70.00

-228.57%

-$160.00

1

$603

-34.13%

-$206

$126.00

-119.74%

-$150.87

2

$1,205

-8.88%

-$107

$201.60

-60.38%

-$121.72

3

$2,170

3.74%

$81

$282.24

-28.00%

-$79.02

4

$3,472

10.05%

$349

$366.91

-10.33%

-$37.92

5

$4,860

13.20%

$642

$440.29

-0.70%

-$3.08

6

$6,561

14.78%

$970

$515.14

4.55%

$23.46

7

$8,530

15.57%

$1,328

$587.26

7.42%

$43.58

8

$10,236

15.97%

$1,634

$651.86

8.98%

$58.56

9

$11,259

16.16%

$1,820

$704.01

9.84%

$69.25

10

$11,822

16.26%

$1,922

$739.21

10.30%

$76.15

As the margins move towards target levels and revenues grow, the operating income at each of the three firms also increases.

As the margins move towards target levels and revenues grow, the operating income at each of the three firms also increases.

Market Size, Market Share and Revenue Growth Estimating revenue growth rates for a young firm in a new business may seem like an exercise in futility. While it is difficult to do, there are ways in which you can make the process easier.

• One is to work backwards by first considering the share of the overall market that you expect your firm to have once it matures and then determining the growth rate you would need to arrive at this market share. For instance, assume that you are analyzing an online toy retailer with $100 million in revenues currently. Assume also that the entire toy retail market had revenues of $70 billion last year. Assuming a 3% growth rate in this market over the next 10 years and a market share of 5% for your firm, you would arrive at expected revenues of $4.703 billion for the firm in ten years and a compounded revenue growth rate of 46.98%.

Expected Revenues in 10 years = $70 billion * 1.0310 * 0.05 = $4.703 billion Expected compounded growth rate = (4,703/100)1/10 - 1 = 0.4698

• The other approach is to forecast the expected growth rate in revenues over the next 3 to 5 years based upon past growth rates. Once you estimate revenues in year 3 or 5, you can then forecast a growth rate based upon companies with similar revenues growth currently. For instance, assume that the online toy retailer analyzed above had revenue growth of 200% last year (revenues went from $33 million to $100 million). You could forecast growth rates of 120%, 100%, 80% and 60% for the next 4 years, leading to revenues of $1.267 billion in four years. You could then look at the average growth rate posted by retail firms with revenues between $1 and $1.5 billion last year and use that as the growth rate commencing in year 5.

Sales to Capital Ratio

High revenue growth is clearly a desirable objective, especially when linked with positive operating margins in future years. Firms do, however, have to invest to generate both revenue growth and positive operating margins in future years. This investment can take traditional forms (plant and equipment) but it should also include acquisitions of other firms, partnerships, investments in distribution and marketing capabilities and research and development.

To link revenue growth with reinvestment needs, you look at the revenues that every dollar of capital that you invest generates. This ratio, called the sales to capital ratio, allows us to estimate how much additional investment the firm has to make to generate the projected revenue growth. This investment can be in internal projects, acquisitions or working capital. To estimate the reinvestment needs in any year, you divide the revenue growth that you have projected (in dollar terms) by the sales to capital ratio. Thus, if you expect revenues to grow by $1 billion and you use a sales to capital ratio of 2.5, you would estimate a reinvestment need for this firm of $400 million ($1 billion/2.5). Lower sales to capital ratios increase reinvestment needs (and reduce cash flows) while higher sales to capital ratios decrease reinvestment needs (and increase cash flows).

To estimate the sales to capital ratio, you look at both a firm's past and the business it operates in. To measure this ratio historically, you look at changes in revenue each year and divide it by the reinvestment made that year. You also look at the average ratio of sales to book capital invested in the business in which the firm operates.

Linking operating margins to reinvestment needs is much more difficult to do, since a firm's capacity to earn operating income and sustain high returns comes from the competitive advantages that it acquires, partly through internal investment and partly through acquisitions. Firms that adopt a two-track strategy in investing, where one track focuses on generating higher revenues and the other on building up competitive strengths should have higher operating margins and values than firms that concentrate only on revenue growth.

Link to Return on Capital

One of the dangers that you face when using a sales-to-capital ratio to generate reinvestment needs is that you might under-estimate or over-estimate your reinvestment needs. You can keep tabs on whether this is happening and correct it when it does by also estimating the after-tax return on capital on the firm each year through the analysis. To estimate the return on capital in a future year, you use the estimated after-tax operating income in that year and divide it by the total capital invested in that firm in that year. The former number comes from your estimates of revenue growth and operating margins, while the latter can be estimated by aggregating the reinvestments made by the firm all the way through the future year. For instance, a firm that has $500 million in capital invested today and is required to reinvest $300 million next year and $400 million the year after will have capital invested of $1.2 billion at the end of the second year.

For firms losing money today, the return on capital will be a negative number when the estimation begins but improve as margins improve. If the sales-to-capital ratio is set too high, the return-on-capital in the later years will be too high, while if it is set too low, it will be too low. Too low or high relative to what, you ask? There are two comparisons that are worth making. The first is to the average return-on-capital for mature firms in the business in which your firm operates - mature specialty and brand name retailers, in the case of Ashford.com. The second is to the firm's own cost of capital. A projected return on capital of 40% for a firm with a cost of capital of 10% in a sector where returns on capital hover around 15% is an indicator that the firm is investing too little for the projected revenue growth and operating margins. Decreasing the sales to capital ratio until the return on capital converges on 15% would be prudent.

Illustration 11.14: Estimated Sales to Capital Ratios

To estimate how much Commerce One and Ashford.com have to invest to generate the expected revenue growth, we estimate the current sales to capital ratio, the marginal sales to capital ratio in the last year and the average sales to capital ratio for the businesses that each operates in.

Table 11.16: Sales to Capital Ratio Estimates

Commerce One

Ashford.com

Firm's Sales to Capital

3.13

1.18

Marginal Sales to Capital: Most recent year

2.70

1.60

Industry average Sales to Capital

3.18

3.24

Sales to Capital Ratio used in valuation

2.00

2.50

We used a sales to capital ratio of 2.50 for Ashford.com, approximately midway through their marginal sales to capital ratio from last year and the industry average. For Commerce One, we set the sales to capital ratio well below the industry average and the firm's marginal sales to capital ratio. We feel that as competition increases, Commerce One will have to invest increasing amounts in technology and in acquisitions to grow.

Based upon these estimates of the sales to capital ratio for each firm, we can now estimate how much each firm will have to reinvest each year for the next 10 years in Table 11.17.

Table 11.17: Estimated Reinvestment Needs

Commerce One

Ashford.com

Year

Increase in Revenue

Reinvestment

Increase in Revenue

Reinvestment

1

$201

$100

$56

$22

2

$603

$301

$76

$30

3

$964

$482

$81

$32

4

$1,302

$651

$85

$34

5

$1,389

$694

$73

$29

6

$1,701

$851

$75

$30

7

$1,968

$984

$72

$29

8

$1,706

$853

$65

$26

9

$1,024

$512

$52

$21

10

$563

$281

$35

$14

As a final check, we estimate the return on capital each year for the next 10 years for both firms in Table 11.18.

Table ¡¡.¡8: Estimated Return on Capital

Year

Commerce One

Ashford.com

1

-160.23%

-254.67%

2

-46.80%

-149.09%

3

15.30%

-70.62%

4

34.46%

-26.31%

5

32.17%

-1.73%

6

26.74%

11.31%

7

26.91%

18.36%

8

25.34%

22.00%

9

23.44%

23.72%

10

22.49%

24.34%

Industry average

20.00%

20.00%

The returns-on-capital at both firms converge to sustainable levels, at least relative to industry averages, by the terminal year. This suggests that our estimates of sales to capital ratios are reasonable.

^L.-.--'! margins.xls: This dataset on the web summarizes operating margins, by industry, for the United States.

Was this article helpful?

0 0

Post a comment