There’s More to Earnings than Earnings per Share
Capital expenditures are an overlooked lever for helping companies boost cash flows — and ultimately shareholder returns.
The business media, financial analysts, and many management teams are intensely focused on corporate earnings. Business commentators obsess about what a company’s earnings per share (EPS) were last quarter, how they compared with last year’s quarter, and what they are expected to be in the next quarter. Management teams often rationalize their cost structures so they can drive faster earnings growth.
But the focus on EPS misses half the story. Although EPS is an important part of value creation, it is only one side of the value equation. Cash is king, and a company’s value is ultimately driven by market expectations of future cash flows. On top of managing earnings, managing cash flows means making the most of the investments of capital that were made to generate those earnings, such as buying equipment, funding research and development outlays, and paying for acquisitions. Although companies have made great strides in optimizing earnings, many struggle — or fail — to bring the same rigor to capital spending.
Improving capital allocation, defined simply as where companies choose to spend their cash or make their bets, can generate substantial improvements in returns on capital expenditures, and thus in shareholder value. That is especially so in capital-intensive industries. Indeed, companies that are applying discipline and science to the practice of capital allocation are already seeing significant improvements in their cash flows, and hence in their share prices. The key is to develop a robust valuation methodology, apply it using sophisticated optimization tools, and create a comprehensive governance process to support the efforts. To cite one example: After imposing a standardized value framework focused on the key drivers of value and running the portfolio through an optimization model, a major energy company reduced its capital expenditures by 50 percent while generating the same returns.
The recent passage of far-reaching U.S. tax reform legislation has given a further impetus to revisiting how capital is allocated. Much lower rates, the full deduction of capital expenditures, a territorial tax system, caps on interest and executive compensation deductions, minimum taxes on foreign income, and changes to pass-through provisions fundamentally change the cash flows and returns generated by a company’s strategy and investments. These changes can dramatically alter the after-tax cash flows from different investments.
The need for improvement is obvious. As shown below, levels of capital expenditure vary significantly by industry. In industries such as utilities, energy, transportation, telecommunication services, and automobiles and components, companies reinvest more than 50 percent of operating cash flows in the business each year in the form of capital expenditures. The investments a company makes, their growth, and the timing of benefits determine the future value of the company.
But within industries, the relative return on such investments varies significantly. For example, when we compared the level of capital expenditure with expected future revenue growth for 32 companies in the energy sector, we found that a number of those devoting the highest share of cash flows to capital expenditures were expecting anemic growth (see “Energy Industry Consensus Analyst Growth vs. Capital Expenditures as a Percentage of Operating Cash Flows”). This suggests that many of the investments that companies make may in fact generate negative returns for their shareholders.
Creating a New Framework
Management teams often struggle to achieve consistent, positive returns because analyzing and optimizing capital expenditures is a complex task. It requires that management evaluate in some cases hundreds of investments, and prioritize them under a number of financial and nonfinancial constraints to decide which projects to fund, and in what order. The allocation process requires three elements: a robust valuation methodology, sophisticated optimization tools, and a comprehensive governance process.
Valuation. Companies need to start with a standardized, robust valuation methodology at the individual project level that captures the full spectrum of benefits, as well as the relevant risk profile and distribution of potential outcomes. This is similar to the analyses that many companies do of their existing business portfolios, and is rooted in the logic of value investing, exemplified by Warren Buffet and his former mentor, investment scholar Benjamin Graham (see “The Real Value of Your Company,” by Aaron Gilcreast and Larry Jones, s+b, October 2, 2017). But understanding the drivers of financial value is just the beginning. Companies must grasp and quantify the contribution of each project along key nonfinancial strategic value drivers such as regulatory effects, and the impact on stakeholder perceptions and innovation, security, environment, and health and safety. Although these components may be more difficult to quantify, they can be significant contributors to a company’s long-term value.
Many of the investments that companies make may in fact generate negative returns for their shareholders.
When using this approach to assess its R&D portfolio and evaluate risk at both the project and portfolio level, a large technology company with a multibillion-dollar capital investment portfolio was able to reduce its exposure to volatile energy costs, quantify the probability the portfolio would meet its key performance indicators, and assess the downside risk profile. As a result, it was able to communicate R&D project value more effectively to key stakeholders. A robust approach may require visibility into the whole range of possible value and risk outcomes for the project. For some projects, adaptive management reactions to learning events can create option value by enabling leaders to change course based on new information.
Optimization. Once candidate projects have been valued, a sound methodology for allocating capital at the portfolio level can provide insights into key drivers of value and risk at the portfolio level. Allocating capital at this level enables managers to make optimal trade-offs in capital deployment in order to maximize returns. This is where the complexity of the effort can overwhelm some management teams, and simple math shows the difficulty of making these trade-offs. For example, if you have two projects to choose from, you have four alternatives: fund both, fund neither, fund only project one, or fund only project two. In practice, however, companies have many more than two investment options — and many of them are related (e.g., project one is required in order to do project two; synergies/dis-synergies accrue if projects three and four are done together, projects one and three are mutually exclusive). If a company has even 10 such prospective projects, millions of potential permutations exist. Because no human can make such calculations, management teams tend to use rules of thumb and their business judgment to make these decisions. Despite their best efforts, the results will usually be suboptimal.
The capital allocation process and methodology thus need to be supported by a capital allocation decision-making tool that is sufficiently flexible to accommodate the organization’s valuation framework and methodology, and that can capture interdependencies, multiple mutually exclusive versions of candidate projects, various levels of mandates, and a variety of financial and operational constraints. It should also allow for real-time scenario analysis of value drivers such as commodity prices and competitor behavior, and for slicing and dicing the portfolio into relevant sub-portfolios (e.g., geography, business unit, investment type). It also needs to be flexible and robust enough to handle the millions of potential permutations, to provide significant visibility into the portfolio, and to respond promptly to new information and unexpected events. Such a tool allows companies to input all the key value and risk impacts, dependencies, versions, and so on for an investment candidate, and provides insights into the optimal combination of projects to fund for any given level of financial and key operational constraints, rather than leaving value on the table by prioritizing with a “rank and stack” or similar approach.
Governance. Like any other significant organizational change, a capital allocation solution needs to be supported explicitly by senior management. But to succeed, the tool and methodology must also be embedded in governance processes, such as project management and finance procedures, data quality review and budgeting processes, project execution management, and post-allocation measures of success. It is critical that the tool be flexible enough to accommodate the specific culture and process needs of the organization: The best methodology and tools are useless if the company does not also have the capabilities, incentives, and governance in place to ensure they are applied consistently across the organization, actual performance is measured, and new evidence is deployed to enhance the value framework and process. For those projects that have received funding, it is important to have reliable data on progress and resources consumed to date, and to establish consistently applied, quantitative key performance indicators informed by strategic goals. In many cases, this requires building in periodic reviews and taking a fresh look at existing projects to include new information and updated assumptions. Management and other key users will need to develop fluency (via training and simulations) with the valuation framework, tools, and outputs so that the tool does not become a black box. Finally, the tool and framework need to be integrated into the annual capital budgeting and performance evaluation process, as well as to be leveraged ad hoc to create agility. This final step is critical to ensure that actions are taken and the desired results are achieved.
Optimizing capital expenditures effectively is a difficult challenge and requires changes in mind-set, tools, and organization, especially because every company is starting at a different point. Some companies, such as the energy company referenced earlier, are already quite sophisticated and ready to move to leading optimization practices; others are not as far along on their journey in improving capital deployment and are making decisions based on heuristics and rules of thumb, or even simply based on what they did the previous year. These companies may benefit from taking incremental steps toward leading practices such as implementing a more robust value framework and leveraging a simple but standardized prioritization model across the business. Regardless of where a company is on the spectrum, there is usually significant upside in moving farther down the path toward leading practices.
The best way to start is with a simple diagnostic of where the company stands with respect to the different components of capital efficiency compared with a benchmark of leading practices or peers. A one-day workshop with the right members of management and specialists can establish a baseline and identify key areas and a customized set of options for the path the company can take to improve its valuation methodology and decide what type of portfolio prioritization or optimization methodologies are needed, along with the tool options and appropriate governance structures.
Whether it is harvesting energy from renewable sources, deploying chatbots to perform customer service, or embedding sensors in machinery, companies are deploying the latest in 21st-century science and management sophistication to improve their performance. Rolling out an effective valuation methodology for capital allocation, and the tools and processes that support it, is a vital step for businesses that wish to keep up.
- Larry Jones is a principal with PwC US in the valuation practice. Based in Chicago, he works with senior corporate and business unit managers to establish the conditions needed to deliver superior performance.
- Ellen Kilpatrick is a director with PwC US in the valuation practice, based in Los Angeles. She advises corporate managers and executives on enhancing capabilities in value-based decision making and aligning capital allocation with strategy to maximize value.