Anybody who has attended our courses knows that we applaud companies who talk not only about their earnings but also about the returns they are making on the capital they are using. Increases (or decreases) in EPS tell you just that – they have increased or decreased, but no more. Much more interesting for investors is how much capital has been used to generate that growth in EPS, as measured by return on capital invested.
So we always examine the commentary in financial press announcements, particularly in M&A situations, not just for the impact on EPS (such as whether the deal is accretive or dilutive), but also if there’s any comment about whether the deal will cover its cost of capital. Our belief is that this shows that the company understands how investors think.
Yesterday’s announcement from WPP on its $540m acquisition of AKQA actually contained no details of its financial impact on WPP, but what caught my eye was Sir Martin Sorrell’s comments in the FT today when he was reported to have said that the deal would be accretive in the first year and “would meet WPP’s 6.1% cost of capital’. So applause to him for discussing not just the EPS impact but also commenting on the fact that it would cover its cost of capital.
But then, stop for a moment and consider that cost of capital. 6.1%? How on earth does he get to that figure? Measuring the cost of equity capital is an imprecise science, despite what the academics would have you believe with the betas and the risk-free rates, and there’s lots of scope for subjectivity, but you’d go a long way before you found an analyst who’d agree with Sir Martin’s estimate of WPP’s cost of capital. But then, if he was to confess that it was somewhere nearer 9% (which I’d reckon it to be), the acquisition of AKQA would nowhere near cover its cost of capital and be destroying shareholder value. And that would be confessing that he paid too much for it, which investors (being good at this sort of thing) know anyway.
About a week ago I was writing about how it was getting near that time for the politicians and central bankers to intervene. It all that smell about it of ‘Do something or this whole thing is going to blow’. I also wrote that I expected the positive market reaction to last a little less long than it has in the past (the LTRO news boosted the markets for all of about three months).
So the news on the bail-out for Spain was duly announced today amid shouts of ‘Victory for the euro’ from Mr Rajoy and others, and the market’s reaction…..Well, it’s flat after a euphoric 1.5% rise first thing today, but a) watch the currencies and b) of course, watch the Spanish (and Italian, and French) 10 year bond yields. The euro is 1% weaker today against both the pound and the dollar, and Spanish bond yields, far from falling in the wake of the €100 billion rescue, are up to 6.45% as I write. Sorted? Hardly, and that’s after throwing €100 billion at the problem. Over to the politicians and central bankers for more sticking plaster, fast.
What does a good company look like from an investor’s point of view? Well, it would have a large market to go after and, most importantly, a competitive advantage in doing so. And the longer it can maintain that competitive advantage (think Microsoft with Windows), the more profits it will make over time. Investors pay up for companies with these qualities.
They will also pay up for management that understands how to create shareholder value and for high standards of corporate governance, in particular of disclosure and transparency. Which brings me neatly on to Johnson Matthey, which reported its results at the end of last week. JM recorded exceptionally good growth across all of its markets, but look also at the way it tells its story and sets it out on the first two pages with complete clarity. Exactly as we teach it, actually – a box containing the key numbers, five bullets each on financial and operational highlights and a good quote from the CEO, part of which comments on the past year and part of which guides to the future. Faultless. And it scores well on one other key issue. Don’t just talk about Earnings per Share (up 29% at JM) – that doesn’t tell you anything about the amount of capital that’s being invested to grow. Talk also about Return on Capital Invested (or Employed), as JM also does so well (ROCI up from 19% to 22%). The only problem for JM might be the expectations treadmill, but the shares are up 17% over the past year compared to a fall in the FTSE of 5%. Investors are more than happy to pay up for a good story well told.
The debate between Sir Martin Sorrell and WPP investors is warming up nicely. Yesterday, Sir Martin defended himself stoutly in an article written for the FT, much of which I found pretty persuasive. He makes a good case for having created value across the patch – shareholders have seen above average returns over a long period, tens of thousands of employees have jobs and the result today, from a business formed in his front room, is the world’s largest advertising and public relations agency. An extraordinary achievement indeed, and one that he would argue is worth every penny (and more) of what he is paid.
His little local difficulty, however, is that the 60% proposed rise in his pay packet this year compares with WPP’s 10% under-performance against the FTSE during 2011. And that of course is what has got shareholders angry. If they didn’t get their return, why should he?
But this is exactly where the debate should be – working out how best to link management performance with shareholder returns. There has been a considerable shift towards tying the two together over the past 20-odd years, but there are many who would argue that the right measures have not yet been chosen. Too much emphasis on share price growth, for example, means that management may (or indeed, not take) actions which may threaten the price, for example making investments in the short term (such as marketing or R&D costs which will hurt profits) that will benefit the company in future years but only after they have departed and cashed in their options.
We think there are three core measures against which management performance should be judged and each falls neatly into the mantra we teach that says that growth plus returns creates value. The measures are (a) EPS growth, (b) Return on Capital Employed or Capital Invested (ROCE or ROIC), and (c) Total Shareholder Return (TSR, the combination of returns to shareholders by way of dividends and share price growth in any one year). There may be other KPIs that any individual company may choose to add (for example, in a company seeking to grow in emerging markets, the proportion of revenues derived from such markets), but any company that rewards its senior management team on a proportionate combination of these three metrics will find that rows with shareholders like that encountered by Sir Martin are few and far between.
It’s always interesting to take a close look at the press release announcing a deal. People who have been on courses at FinanceTalking know full well about how we go on about the creation of shareholder value, by which we mean that the management of a company generate cash flows at rates of return that exceed the company’s cost of capital. We add that growth matters too, because higher cash flows are obviously more valuable than lower ones. And that’s it really. That’s all that management has to do to create value.
We also teach that there’s too much emphasis on earnings per share. It’s an easy metric to play with because on the face of it the company with higher earnings is making higher profits and then it’s easy to apply a multiple to earnings to get a sense of value – the price/earnings ratio. But what EPS doesn’t tell you is how much capital needs to be invested to generate that growth and it can easily result in two companies with exactly the same revenue and profit profiles into the future being given the same value, even though one company’s cash flows are half of the other’s because of the greater need to re-invest.
So we always look for the bit in M&A releases that talk about the returns the acquisition will make on the capital being invested to purchase it and whether and when the acquisition will cover its cost of capital. No mention of it in the CGI release yesterday on the acquisition of Logica. Just the usual stuff about enhancing earnings per share (albeit by a very healthy amount, which suggests they’re buying it on the cheap). The drafters of the release should check out the bible on Valuation written by McKinsey: “Deals that strengthen EPS and deals that dilute EPS are equally like to create or destroy value.” Talk instead, McKinsey suggest, about the cash flow returns on capital and whether they are in excess of the cost of that capital. That’s creating value, and that’s what will bring investors to invest in the story.
It’s all getting near meltdown out there in the eurozone and the politicians had better come up with something PDQ. All the talk has been of open-ended ECB funding and/or eurozone bonds (effectively the Germans underwriting the periphery’s debts in perpetuity), which many are saying is the only solution. The price to be paid in those peripheral countries will be high – loss of fiscal sovereignty, endless austerity and all bowing to Berlin – and the Germans are probably none too enthusiastic about paying off Spanish and Greek debts for ever either. So nobody wants it and, just for good measure, it’s probably illegal under the EC constitution as well. Make up or break up, Dave? The making-up is a non-starter.
But here’s a thing. Talk to ANYBODY in the eurozone, from Greece to Spain to Finland to Germany, and they ALL want to retain the euro. Yes, even the Greeks. What they don’t like of course is the price they have to pay, but nobody has explained to them properly that the two things live together (look at what Syriza has been saying in the Greek election). The point is that the eurozone lacks democratic legitimacy because the people have never been asked if they support it. It’s just been rail-roaded through by the politicians and all the people can see is bureaucracy from Brussels and control from Berlin. The euro, if you like, had an illegitimate birth through the creation of the eurozone.
So here’s my solution to the euro problem. Ask the people if they want it. My guess is that the answer will be a very strong yes. And, whilst they’re being asked, the politicians should explain the price to them – obey the rules, get the budget deficits down, concede fiscal power to the centre, which of course they won’t like. But at least the people can say they’ve been asked and they’ve chosen a path.
Why has this never been done, you might well ask? It’s because the politicians were afraid the people would say no, of course. And they would have said (and would today say) no the wrong question, for example, do they want to join the EC (with all the stultifying bureaucracy that accompanies that thought coming out of Brussels)? But ask if them if they want to keep the euro and at the same time respect their intelligence by explaining what it means and my belief is that you’ll get a resounding affirmative. I would think it’s a matter of short weeks or months before a bank run in Spain or Greece finishes the whole thing off and then goodness knows what lies ahead. Get the polling done now and give the euro its legitimacy at last. It might even mean a few less riots this summer.