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income by 8 percent through some combination of in- creased sales and margin improvement.16

What kind of return on capital would be necessary to sus- tain that level of income growth? Assuming the compa- ny’s margins remain steady, it would need a return on eq- uity (ROE) of 10 percent in order to fund both its payout and its growth (2 percent to fund a net-income payout of 20 percent, 8 percent to fund enough sales growth to in- crease net income by 8 percent). Of course, if the compa- ny were able to improve margins, the necessary sales growth and therefore the necessary ROE to fund that growth would be less. Alternatively, the more the compa- ny planned to get the required sales growth from acquisi- tions, the higher the necessary ROE because, from an investment perspective, organic growth requires less cap- ital per dollar of incremental sales than growth from mergers and acquisitions (M&A).

This is, of course, a highly stylized example and may seem too simplistic. But when one begins to play with the variables, things get more interesting. Exhibit 5 compares two matrices at two different levels of TSR aspiration, 10 percent and 15 percent (which historically would be top- quartile performance), and at various levels of net- income payout and P/E ratio. A close look at these two matrices reveals a number of fundamental but oen overlooked dynamics.

  • All else being equal, the higher a company’s P/E mul- tiple, the more income growth necessary to create a given amount of TSR—and, therefore, the higher the required ROE. Why? By definition, the higher a com- pany’s multiple, the lower its TSR yield from a given level of cash payout, forcing the company to generate more TSR through income growth. This is precisely the reason why a rising valuation multiple can eventually become a problem for a company pursuing a cash- machine strategy.

  • By the same token, raising cash payout as a percentage of net income lowers the growth necessary to deliver a given amount of TSR. However, at any given P/E multiple (other than ten times earnings), a higher pay- out also greatly increases the ROE required to sustain that payout, even though the necessary level of growth to create a given amount of TSR is less. The reason: the cost of funding organic growth is generally as- sumed to be proportionate to book equity (so, in this

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case, a 10 percent growth in revenue would require a 10 percent growth in book equity), but the cost of cash flow yield is the market value of equity (which, at any P/E ratio above 10, is greater than the book equity). As a result, when P/E multiples are above 10, funding an incremental point of TSR from organic growth requires a lower ROE than funding an incremental point of TSR from net-income payout.

  • A more ambitious TSR target will, of course, require more income growth. But unless a company is pre- pared to take on debt to fund that growth or dilute ex- isting shares by issuing new ones, it puts even greater demands on a company’s ROE. So, for instance, if a company moves from a 10 percent TSR target to a 15 percent target, its ROE must be enough to fund a 5 percent higher level of ongoing reinvestment for growth or a higher level of net-income payout to achieve a 5 percent higher yield, or some combination of the two. Before setting an ambitious TSR goal, a company must be sure that it can reliably fund the mix of growth investments and net-income payouts re- quired to achieve that goal at the company’s anticipat- ed future P/E multiple.

  • Although it is not directly shown on this version of the matrix, margin improvement is a powerful game changer in a company’s TSR profile. On the one hand, it improves a company’s ROE. On the other hand, it also allows a company to reach a given level of income growth with relatively less investment in sales growth. The end result is more net income available for invest- ing in even more sales growth, in M&A, or in addition- al payouts. At the same time, it is important to avoid the trap of overrelying on near-term margin improve- ments as a sustainable driver of meeting aggressive long-term TSR goals, because sooner or later margin improvements reach a point of diminishing returns.

16. The appropriate metrics used to measure the drivers of TSR will vary for any individual company, depending on the nature of its business. But as long as the metrics used are consistent with each other, the dynamics are the same. Margin change can be measured in terms of EBITDA, EBIT, or net income. Valuation multiples can be calculated in terms of the ratio of enterprise value to EBITDA (the EBITDA multiple) or of price to earnings (P/E) multiple. Returns on capital may be measured in terms of return on equity (ROE), return on invested capital (ROIC), or cash flow return on in- vestment (CFROI). In some industries, the signal from different return-on-capital metrics can vary substantially; a company must carefully assess which metric is the most appropriate signal of its ability to finance its TSR strategy.


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