Female athlete jumping over hurdle.
The CFOs I spoke to said that they worry instead about long range plans, rank ordering the best projects in terms of expected returns, ROIC and EPS growth and less about getting WACCs and hurdle rates to be precise.
In my CFO classes, I often get asked, "What is the right hurdle rate for a capital budgeting project? Which valuation model should I use to evaluate the viability of a project? How should I think about cost of capital?"
Continuing my series on capital allocation, I asked seven CFOs how they come up and use hurdle rates for capital allocation projects. A related question is their thinking on WACCs (weighted average cost of capital) and the valuation models they use to evaluate capex investments.
The impression I got was that academics potentially obsess over hurdle rates, WACCs and exact valuation models more than they should. Here are the detailed findings:
1. Pseudo precision on WACC is useless. Focus on ROIC instead:
“I would simply call the banks and ask them what my WACC is.” The same CFO continued:
“When we meet the sell-side and buy side analysts, we'd ask them what numbers for WACC they came up with, and we'd get them to explain if there were differences from the numbers we calculated, and there was kind of a dialogue about it.
But I wasn't really that worried about the exact numbers. The fact is our return on capital was below our cost of capital, no matter how you measured it. What was important was improving return over time. We were more focused on consistent improvements in the ROIC.
If you talk to the sell-side people, some of these guys are adjusting for this, adjusting for that. You can't even keep track of the twists and turns. One analyst did it this way, another person did it that way. So, we would tell people: ROIC is what we're going to talk to you about. We will try and improve ROIC over time.”
2. Operational people need something simple to maximize such as ROIC:
“Part of the problem is when you're talking to operating people, you know, guys who are not in finance, you've got to turn these conversations into things that are really, really simple. If you start getting too theoretical on this stuff, they have no idea what you're talking about. The challenge in all these companies is, it's sort of a theory to practice thing. How do you operationalize this stuff?
I mean, it's really easy to sit around and talk theoretically about, you know, your WACC and whatever Merton Miller said way back then. You can't get a guy who's the general manager of Southern California, to operationalize, say EVA (economic value add). I would watch these companies try and operationalize EVA, you know and see them tie themselves in knots.
You have to turn it into something that's very simple like “ROIC needs to go up 25 basis points a year.” Or, you have to say, our margin needs to go up 20 basis points a year, and here's how you do it. And then that math hopefully maps over into the EVA calculation. “
3. Focus on EPS growth instead of worrying about cost of capital too much:
“We knew that if we could get to say organic EPS growth of 8% and then maybe get another point or two from share buybacks, 1% to 2% top line growth, and we improved our return on invested capital, we are OK. We knew that if we could build that kind of momentum and sustain it, over time our share price would actually do really well.”
4. DCF and other models’ usage less important than other constraints such as leverage limits:
“We used typical NPV modeling to actually evaluate specific investments. That was for the basic kind of ongoing capex. Then we did do a fair amount of acquisitions. We did multiple billions of dollars of acquisitions over time, and those were more just driven by what was the business opportunity that came up. We did run the usual valuation models, NPV and IRR calculations for acquisitions. But this was more of a math exercise, I think, sometimes.
More important was that we had the debt raising capacity. So if we wanted to do a billion and a half dollar acquisition, we could do it because we had a fairly conservative leverage structure.”
5. Long horizon NPV calculations not practical given short-term pressures:
“People would show me these acquisitions and, say, oh, look at the IRR. 25% IRR, the NPV is huge and all that stuff, and then you look at it, yeah, but 90% of the value is terminal value. And that's 10 years from now. Or maybe it's even 20, it depends on the model. Who the hell knows what's going to happen 15-20 years from now? So again, the theory would say that's the right way to do it, but if you're really focused, you have got to be execute from day one on the acquisitions, because 15 years from now is a lifetime.”
6. Bottom-up long-range planning dictates capex more than hurdle rates:
“One of the things that makes us a very special place is that this is a company that has been willing to make those kinds of long-term bets that have not been all that popular in the near term with our shareholders.”
“Every year we have a budget process, and we draft a five-year long-range plan. The long-range plan is top down rather than bottoms up. The budget process is bottom-top. The budget process starts with the individual business units. Then it bubbles its way up and there's some top-down judgment involved. So, this is kind of a bottom-top hybrid model.
The budget is carefully scrutinized. Years one and two of the long-range plan are given a meaningful amount of thought. As you move further into the future, people spend less time thinking about it, and most companies will have some type of hockey stick forecast in terms of financial performance and capital usage intensity. So that's kind of one moment in time when capex gets decided and capital gets allocated.
The others are kind of ad hoc moments. And those are when we look through acquisitions. Or there are points in time when our strategy changes. Or if something out of the ordinary in the planning process happens and we need to sit back and take a relook at capital allocation.”
7. Rank order expected returns from the best projects you have. Ignore marginal projects:
“The cost of capital depends on the particular segment or the business and the country you are investing in. Investors may view cost of capital differently than management does because investors may not want to invest in a particular foreign country whereas the company has a lot of experience investing there. On top of that, you have to worry about comparing fairly certain returns in a project versus uncertain returns in other projects.
What you ideally want to get is a rank ordering of expected returns from the best projects you have. Make sure you are investing in good businesses. There's no sense investing to make a small incremental return relative to cost of capital.”
Bottomline:
So, the bottom line here seems to be that most CFOs worry about long range plans, rank ordering the best projects in terms of expected returns, ROIC and EPS growth and less about getting WACCs and hurdle rates to be precise. Have academics potentially spent too much time worrying about the exact form of valuation models used, the nuances between cash flows or earnings or EVA as the valuation metrics used and the associated cost of capital?
The real world heuristic may be as simple as rank ordering projects by expected returns or ROIC and getting rid of the marginal projects.
