Highly profitable companies earning a very high return on capital should be viewed with skepticism. Why? Because they may not be maximizing shareholder value as they defend a high P/E ratio, and not capturing good, but lower P/E opportunities. Maximizing profitability is not the same as maximizing shareholder value.
We illustrate this with a simple model. But it will also hold true in a fully-fledged DCF model.
In Case A, we have Company A that has one business unit with invested capital of $1 billion. It earns a high return on capital (ROC)–30%–and it’s cost of capital (COC) is 10%. In year 10 the high ROC falls back to the COC. The annual profits are reinvested in the business and earn the same return, but the company can not grow any faster than this in this business unit even if it had more capital available.
The resulting value of this company is $7.1 billion and the P/E ratio is 24.
Management of the company faces the question of whether it should invest in a second business unit. This unit would have an ROC of 12% and a COC of 10%. It would need $400 million of capital.
Because of the much lower profitability, management decides against expansion because it fears the stock market would react negatively to the resulting lower relative profitability.
In Case B we have an identical company with the difference that management decides to invest in the second business unit. The first business unit has the same value as Company A. In addition, company B derives a value of $521 million from the second business unit with a P/E ratio of 11. The combined P/E ratio is 22.
REAL LIFE EXAMPLE 1
A global US publicly traded food company has enjoyed ROC of more than 40% for decades, but with low growth. No matter where management looked it could not find profitable enough acquisition opportunities. Profitable in the sense of generating similar ROC.
Seeing an opportunity, another company successfully bid for the food company. It then complemented the profitable business with other businesses that had high, but not as high ROC. The resulting company creates significantly more shareholder value even though the new ROC is lower, as is the P/E ratio.
REAL LIFE EXAMPLE 2
A country subsidiary of a global company has enjoyed spectacular profits for many years (in fact much higher than the 30% ROC seen in the example above). Over the last few years, two new market opportunities have opened up. One is to expand into new distribution channels, the other is to introduce a new product. Both opportunities have high, but not spectacularly high ROC (i.e. ROC > COC, but not ROC >> COC).
Local and global management has repeatedly decided against these expansions because they fear the lower ROC will hurt the stock market valuation. As a result, potential shareholder value is left on the table (destroyed if compared to what could have been).
Enjoying extraordinarily high return on capital is of course attractive. Management should certainly strive for the highest ROC possible. But this is not the same as saying that potential new opportunities should be avoided because they have lower profitability. As long as they earn their cost of capital and fit within the company’s core capabilities, they should be pursued. Many highly profitable companies ranging from Apple to Toyota may be too myopically focused on maintaining the current highly profitable business.