Companies Should be Viewed As Investment Conduits

30 Oct

We think that the best way to view a company is as an investment vehicle. This is what corporate management is paid to do – invest shareholder capital in areas where attractive investment returns are (hopefully) available.

At its base, a business invests capital in a collection of projects, products, or services and hopes to earn a return commensurate with the risk taken. It wants to earn a return on its invested capital – that is, equity and debt invested. And over time, the business will create wealth if it can earn above its cost of capital.

For a simple example, we’ll ignore taxes and consider a piece of real estate worth $1 million. Perhaps the buyer puts down 20% ($200k) of the purchase price, leaving $800k to be financed with debt at an 8% interest rate. So, the debt portion must earn enough in rent to pay costs plus an 8% (net of tax) payment to at least break even. That is, costs (maintenance, management, insurance, taxes, etc.) plus $64,000 to pay the principal and interest (P&I) on the loan. This is break-even on the debt portion.

The equity (20%) portion is a little trickier since it doesn’t actually have an explicit cost. Yet according to economic theory, this portion should be assigned an opportunity cost. For example, the opportunity forgone to invest in a similarly risky stock or bond that would earn 10%. Thus, this portion should earn costs plus 10% to earn an economically break-even return – $20,000 after costs.

In order to earn an excess economic return, returns must be greater than the weighted-average of these capital costs – [(.20×10%)+(.80×8%] = 8.4% after costs to break even in economic terms. So if the investment earns 10%, there is a 1.6% excess return (10%-8.4%). This is how economic wealth is created.

Many companies do not earn long run returns above their cost of capital, so how do they go on living? Certainly if it can’t pay its debts it should be bankrupt! Well, as I mentioned, the equity portion of capital does not really have an explicit cost, so a company can still cover its explicit debt costs while eroding the returns to equity.

Same thing in the real estate example. If it only earns 7% on the entire building after costs, it still has $70,000 to cover the $64,000 P&I. Ignoring principal payoff and appreciation, this leaves only $6,000 for the equity portion – a 3% return on the equity. If such a situation is expected to continue, this capital would be better employed in a money market account earning 5%. The exact same concept applies to publicly traded companies, albeit on a more complicated scale.

The bottom line is that we want a company to, say, borrow at 7% what it can invest at 15%, earning the “spread” of the investment return minus its cost of capital. This is, at its base, what every company is trying to do whether it sells steel, toilet paper, tax preparation, or owns real estate. Earning a return on its investments above the cost of the funds in the long run generates economic value for shareholders.

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