At any given moment there are likely multiple factors influencing the price of a particular investment asset. The fundamental driver of investment returns over the long term is growth in the asset’s ability to generate free cash flow (per unit of ownership, but this is for another day). The generation of free cash flow enables a reinvestment in the asset with the objective of producing incremental free cash flow over the subsequent period. To simplify, picture a business consisting of a large portfolio of rental homes. Using the free cash flow generated one year, the owner purchases a few more homes. The following year, more cash is generated, and the process is repeated. While this obvious cycle of business investment had been a key source of asset value growth since the dawn of capitalism, it has been shown to be extremely difficult for an investor to generate returns in excess of this Return on Invested Capital (“ROIC”) of the underlying asset.
Although ROIC has many permutations, for the purpose of this post it will represent the basic unlevered free cash flow generated by a business (after taxes, but before any growth-oriented capital expenditures), divided by the total capital funding of the business:
It is an imperfect metric that often needs to be customized for a specific investment opportunity, but the idea is to identify how much “re-investible” cash a business is generating relative to the amount of capital the business has invested in its own cash-generating assets.
If a company generates cash that it can use to invest in its current line of business, it can simplistically be expected that this incremental cash investment will generate the same ROIC as the existing business. Shown below in Figure 1 is the hypothetical rental-home business compounding its growth through continued reinvestment in its asset base, self-funded through its own Return on Invested Capital. As the cash flow stream grows over time, it is intrinsically more valuable to the owner. This growth in cash flow, over the long run, is what typically generates investment returns.
There are several key hurdles to the investor in generating returns equal to or greater than the compounded ROIC of the underlying asset. Primarily: taxes. An enormous chunk of investor value is soaked up by Uncle Sam. Given that any crystallization of an investment gain will result in significant leakage, the investor is, by default, at a disadvantage in generating returns comparable to the after-tax ROIC realized by the business or asset. In Figure 1 above, the realized after-tax returns for the investor are highlighted in grey. Although the business is generating annual returns of 10%, the investor only realized 8.6%. This difference may seem insignificant, but over long periods of time this difference in compounded annual return can have truly astonishing implications for investor value.
Two key assumptions in the table above are (1) the multiples of cash flow used to value both the initial investment and (2) the sale of the investment. Valuation multiples come in many forms (price-to-earnings, EBITDA, revenue, cashflow…), but in most circumstances they are utilized as a shortcut for the investor to ascribe a value to an investment that renders it comparable with other investment opportunities. The two typical drivers of valuation multiples tend to be either (1) the predictability of the denominator relative to price paid for the denominator value, or (2) the growth (real or expected) of the denominator, also relative to price. An example may include a long dated, high quality bond or other fixed income asset, or real estate, which often includes a reliable income stream. Cash flows from these assets, due to their predictability or contractual nature, are often ascribed high multiples in the marketplace. Separately, a start-up enterprise that earns comparatively little cash flow today may command a high multiple relative to current earnings power due to the expectations of future cash flow growth. Opposite characteristics of these examples, such as unpredictability in cash flows or expected earnings declines, can also be drivers of lower valuation multiples in the marketplace.
Multiples (i.e. valuation) are important as they provide the only real mechanism for an investor to outperform the underlying ROIC of the asset – buy low, sell high. In Figure 2 below, an example is shown of an investor buying and selling the same cash flow stream as previously depicted, but with the benefit of lower purchase and higher sale multiples.
Just like the rental home company recycles its own investable cash in an attempt to generate additional future cash flows, the investor recycles his cash in the securities representing ownership of the underlying assets. The natural fluctuations in the marketplace of ascribed valuation multiples give the investor the opportunity to capitalize on any deviation from what he or she ascribes as fair value. In this example, only the successful recycling of capital at purchase multiples lower than those of the sale multiples can enable the investor to both make up for tax leakage on gains and outperform the Return on Invested Capital of the underlying assets.
Of course, the strategy of consistently churning investments at high multiples and repurchasing them at low multiples comes with many risks: One key risk is in regards to timing of the reinvestment. In Figure 2, the investor is assumed to remain uninvested during Year 5, and for the period makes no return on his money. In the case of an investor sitting in cash, not only is he or she not generating investment returns, he is actually diminishing his own purchasing power through the erosion of inflation. The time lag between appealing investments can last far longer than shown in this example, and if extended for too long can decimate investor returns relative to ROIC. Given its natural unpredictability, the market simply cannot be expected to consistently provide timely reinvestment opportunities.
The negative impacts of taxes are also amplified in a scenario where an investor chooses to churn his or her money. The more frequently gains are realized, the higher are the required future returns to offset the tax leakage and maintain trajectory of investor returns. Each profitable sale ups the ante for future required performance.
But all is not lost for the investor as there are other ways to converge realized returns to that of underlying asset ROIC. One method is simply time. The longer the investor waits to monetize the investment and realize his or her gain (assuming the same purchase and sale multiple), the closer the realized IRR is to that of the underlying company ROIC. Said differently, if Figure 1 above is extended to include a full individual lifetime investment horizon of 40 years, the after tax IRR for the investor would converge to 9.4% versus 8.6% after 10 years. Again, these seemingly minimal discrepancies in return can have tremendous absolute dollar impacts for an investor over many years.
Purchase and sale multiples have a similar diminished impact over long periods of time. Even if one pays a relatively higher multiple to acquire a high ROIC asset, and sells the asset at a lower multiple after an extended time horizon, the compounding effect of the high ROIC asset goes a long way to negate the impact of the valuation multiple mismatch. Although you cannot close the gap on realized IRR and underlying asset ROIC through these methods, on high quality assets the investor can still realize exceptional returns over time.
Although other systems exist to structure investments such that they outperform the underlying business performance (i.e. leverage, cash flow reallocation), it is easy to see the hurdles an investor generally faces in outperforming the underlying asset class. Time is the friend of an investor if they simply want to approximate the ROIC of the underlying asset, and if outperformance is the objective, the age-old adage will always apply: Buy low, sell high.
About the Author:
Jacob D. Chase is currently an investment professional at one of the world’s leading distressed debt hedge funds and is a Managing Partner of The Denver Fund, a privately held residential real estate investment vehicle. Prior to his current roles he worked as a restructuring advisor at Lazard Frères.
Jacob is a lifelong student of investing, and has a BA in Finance from the Daniels College of Business at the University of Denver.