Cost of capital: an important item in the investor toolbox

That listed companies the world over are becoming less profitable doesn’t sound so surprising. That there has been a trend of drooping corporate profitability for approaching 20 years now might be a bit of a shock, however. Yet that’s how it is, according to McKinsey & Co, the world’s biggest management consultant by revenue.

The consultancy – never known to do things by half – bases its assessment on the aggregated accounts since 2005 of the world’s 4,000 biggest quoted companies by revenue. Dividing this period into successive five-year blocks, it found that the 4,000 averaged $612bn (£491bn) annual profit in 2005-09, which fell to $570bn in 2010-14 then flopped to $297bn in 2015-19. True, profit rebounded in 2020 and 2021, but that was largely due to the massive – and surely untypical – post-Covid bounce of 2021.

As to why the trend has been consistently down, McKinsey is better at describing it than explaining it. It found that to be successful in the past 10 years or so – and here I exaggerate – a company needed one of three characteristics (and preferably all three): to be American, to be big already and to be operating in the technology sectors. For companies operating outside those boundaries, the going was tough.

Europe is failing to keep up with the US

“Europe has demonstrably failed to keep up with North American companies,” says McKinsey. Comparing 2015-19 with 2005-09, American-based companies, excluding those in the energy and materials sectors, took their share of global profit from 50 per cent to 77 per cent; and, in 2015-19, North American companies generated 3.5 times more profit than Europeans. Simultaneously, the 500 biggest companies of the 4,000 raised their share of global profit from 82 per cent in 2005-09 to 97 per cent in 2015-19 even though their share of global revenue stayed constant. In North America, technology companies raised their share of profit from 22 per cent in 2005-09 to 36 per cent in 2015-19, although other sectors were also strong; in particular, advanced industrials, whose profit share tripled from a low base, and pharmaceuticals, whose bigger share rose by over a third.

Digging a little deeper, McKinsey breaks down the change in profit into five driving factors: changes in revenue, in profit margins and in capital turnover; plus changes to the ratio of intangible capital to total capital and to the cost of capital, which – in some ways – is the most important factor, as we’ll see. The consultant found that almost all the increase in profit came from growth in revenue and – especially – from widening profit margins among North American companies, as Dan Jones discusses here. These were offset by less efficient use of capital, a rising cost of capital, and especially by the familiar story of resources wasted on mergers and acquisitions that failed to produce the growth and efficiencies company bosses had touted.

Maybe this is where it gets most interesting. McKinsey’s research is based on a particular type of profit, which it labels ‘economic profit’ to distinguish it from ‘accounting profit’, the measure found in company accounts. Simultaneously, this makes McKinsey’s findings especially important, but, in another way, it diminishes them.

To explain, let’s discuss ‘economic profit’, which is a concept all equity investors should understand and apply when they assess whether a company’s shares are cheap or expensive. It is based on the simple notion that a company is only really profitable when its return on capital is higher than its cost of capital. In a way, that’s just common sense. After all, if I borrow money that costs me, say, 5 per cent, I can only use that capital profitably if I get a return higher than 5 per cent; below 5 per cent and more cash will be going out than coming in. From this logic, economic profit is defined as a company’s return on invested capital minus the weighted average cost of its capital, and it is quantified by multiplying the amount of capital employed by the gap between percentage return and percentage cost. If a company employs £1bn of capital and the spread between the return on capital and its cost is 2 per cent, then economic profit is £20mn a year, to be distributed pro rata between the owners of its debt and its equity.

Of course, that is not the way company accounts work. Thus many companies can declare an accounting profit even though their cost of capital is higher than their return on capital. One such shown in the table is Vodafone (VOD). The mobile phone operator’s cost of capital, based on the average of analysts’ forecasts, is 6.2 per cent yet its forecast return on capital is just 2.3 per cent. Using slightly different figures, which aren’t really comparable with those percentage numbers, this boils down to forecast economic profit of about £3.6bn, which is just marginally more than forecasted accounting profit. By contrast, companies whose return on capital is far ahead of their cost of capital show economic profit well ahead of accounting profit. Take the tech giant Amazon (US:AMZN) – its return on capital is more than twice its cost (6.5 per cent to 2.7 per cent) and, similarly, economic profit, at $17.8bn, is more than twice accounting profit of $8.3bn.

In that sense, McKinsey’s findings are particularly important because they are based on a measure of profit that is ‘real’; that is free from the oddities by which accounting rules distort company profits (all that deferred income, capitalised costs and what not).

Yet simultaneously its findings are diminished because, actually, economic profit is as unreal as accounting profit. It, too, is based on its own set of assumptions, the most important of which concerns the cost of capital and, in particular, the cost of the equity portion of capital.

Quantifying the cost of a company’s debt is straightforward. At least, it is if a company reveals the interest rates its lenders charge. This will vary from tranche to tranche, some of which will be at fixed rates, some of which variable. No problem. Nowadays, many City analysts estimate these on a weighted average basis, which probably explains why the cost of debt shown in the table varies little from company to company (although, in truth, the cost for Renishaw (RSW) is just a guess).

Estimating cost of equity

However, perhaps the real guesswork comes in estimating a company’s cost of equity. That’s because equity – the capital contributed by ordinary shareholders – has no specific cost. After all, companies are obliged neither to pay shareholders dividends nor to pay them a redemption lump sum. Instead, equity carries an implicit cost defined as the likely return that will persuade investors to hold a company’s shares. That still leaves this implicit cost unclear, although finance theory says it is the sum of the returns from holding equities in general plus a premium for accepting company-specific risk. Even that may leave many readers little the wiser, although there are various devices for putting figures on those estimates.

The point is, however, they are just that – estimates; and, in the table, Bearbull’s estimates for cost of equity are as simple as can be. The cost is the forecast earnings yield for each company; in other words, it is the reciprocal of the price/earnings ratio. Amazon’s shares trade on a prospective earnings multiple of 58 times, therefore the cost of equity is 1.7 per cent. At the low end, Vodafone trades on about 10 times, thus its cost of equity is 9.8 per cent.

The merit of using this approach – apart from its utter simplicity (no messing around with the capital asset pricing model, for instance) – is that it aligns with common sense. Companies whose shares are rated highly can issue less new equity to raise a given amount of capital than companies whose shares are lowly rated. Therefore their cost of equity is low.

Interestingly, however, it also highlights what we might label ‘the valuation paradox’. That is, the higher a company’s share rating, the more investors implicitly acknowledge that they like the company so much they are willing to accept a lower return to hold its shares. Yet the paradox is that they buy the shares for precisely the opposite reason – because they expect a higher return. Investors did not pile into Amazon in the early 2000s because they expected low returns. They bought at astronomical ratings but were rewarded nonetheless. Even for Amazon, however, there is a limit to how long that process can continue. Sooner or later, a low cost of equity in a theoretical valuation exercise will be a low return for the investors who bought on high ratings. 

So, despite the reliance on theoretically-based estimates, assessing a company’s performance – and its value – on the difference between its return on capital and its cost of capital remains an important item in an investor’s toolbox. Perhaps it is better at highlighting the losers than the winners; the companies that, year after year, post accounting profit that, as likely as not, is growing even though their return on capital is poor. Chances are, such companies are destroying value and the scale of that destruction is indicated – to an extent quantified – by the degree to which return on capital falls short of estimated cost of capital. That’s a tool well worth having. After all, it’s axiomatic that good investment returns are achieved as much by avoiding losers as by running winners; avoiding those companies the world over that, according to McKinsey, are becoming less profitable, especially as interest rates continue to rise.