How do companies create shareholder value?


Warren Buffett once said that the best business to own was the one that could employ large amounts of incremental capital at very high rates of return over an extended period of time.

Companies with high rates of return enjoy high stock price valuations, presumably because their returns on investments are greater than their cost of capital.

But, when rates of return fall below cost of capital, companies become expensive, which causes their stock prices to fall.

For example, during the bull market in early 2010s, Jollibee was one of those that enjoyed high rates of return, which enabled it to create massive shareholder value over time.

From 2012 to 2017, the average return on invested capital, or ROIC, of Jollibee was 30 percent, way over and above its weighted average cost of capital, or WACC, of only 9 percent.

The wide spread between returns and cost of capital resulted in an excess yield of 21 percent yearly, which compounded Jollibee’s market value to grow by 150 percent in five years.

But in 2018, when Jollibee embarked on big-ticket acquisitions overseas, its ROIC began to fall, from an average of 30 percent down to 21.3 percent.

This decline continued in 2019 as Jollibee tried to turn around its loss-making acquisitions, resulting in a lower ROIC of 17.3 percent until the coronavirus pandemic happened last year, which pulled its ROIC further down to 2.3 percent.

Although Jollibee’s cost of capital remained low, the declining ROICs over recent years have resulted in negative spread of 8.5 percent, which caused its market value to lose 33 percent by end-2020.

The ROIC, which is calculated by dividing the operating profit of a company with its invested capital to represent the sum of its net debt and stockholders’ equity, is a measure that tells us how a company allocates it capital to generate profits.

We learned last week in this column that having low WACC, brought about by lower interest rates, is not enough to create value.

A company must also generate growth from its capital allocations so it can increase its returns over its cost of capital. A positive spread between ROIC and WACC can help create a stronger shareholder value in the long-term.

For the past 10 years prior to the COVID-19 pandemic, the stock market has been on an uptrend on the strength of a growing economy.

The fall in interest rates has allowed many companies to expand, which helped increase their earnings and stock prices, but the buildup of debt over the years also saw the gradual decline in value creation in the market.

The decline in positive spread between the ROIC and WACC from a high of 5.8 percent in 2014 to 2.8 percent in 2018 resulted in an overvalued stock market, which topped out early that year.

Although the spread recovered to 4.9 percent in 2019 as returns improved and cost of capital declined, the coronavirus crisis in 2020 brought down spreads to 3 percent.

Today, most of the companies belonging to the Philippine Stock Exchange index (PSEi) are able to have positive spreads, despite the losses, not because they have high ROICs, but because of lower WACCs.

Interestingly, amid the challenging economic environment, there are also few noteworthy companies that have managed to keep their positive spreads to double-digit returns.

These are Globe Telecom, which has positive spread of 30 percent, followed by PLDT, 20.2 percent; Universal Robina, 16.9 percent; First Gen, 14.9 percent; and ICTSI, 12.7 percent.

The top nonindex stocks with highest spread are Ginebra San Miguel, 48.7 percent; GMA Network, 44.9 percent; Global Ferronickel, 27 percent; Nickel Asia, 17.3 percent; and Apex Mining, 16 percent.

With an economic recovery on the horizon, the return of growth should help improve the average ROICs in the market, which should support further recovery in the PSEi.

However, we should also be aware that there are risks of continued slowdown in the economy, which could prolong the weakening of average ROICs that result in lower stock price valuations. INQ

Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend 88th batch of RFP Program this March 2021.

To register, e-mail [email protected] or text at 09176248110

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