Valuing and Investing in Equities

CROCI: Cash Return on Capital Investment

Francesco Curto

• Publisher: Academic Press
• Year: 2020
• Print ISBN: 9780128138489
• eBook ISBN: 9780128138496
• Topic: Business
• Subtopic: Finance
• Index: Business

Valuing and Investing in Equities: CROCI: Cash Return on Capital Investment develops a common-sense framework for value investors. By distinguishing investors from speculators, it acknowledges the variety of styles and goals in the financial markets. After explaining the intuition behind due diligence, portfolio construction, and stock picking, it shows the reader how to perform these steps and how to evaluate their results. Francesco Curto illuminates the costs and opportunities afforded by valuation strategies, inflation, and bubbles, emphasizing their effects on each other within the CROCI framework. Balancing analytics with an engaging clarity, the book neatly describes a comprehensive, time-tested approach to investing. Annual returns from this investment approach demand everyone's attention.- Describes the Cash Return on Capital Invested (CROCI) methodology- Provides a step by step approach in building investment strategies- Presents 25 years of insights from CROCI's valuation and investment results

Chapter 1

Investment and valuation

Abstract

This chapter introduces the reader to the CROCI framework of looking at the world of equities through a capital and return framework. Analysts, by focusing purely on earnings and earnings dynamics, miss out on developing a better understanding of a company valuation. The chapter also illustrates how all the different valuation ratios are a rearrangement of the investment equation resulting from the work of Luca Pacioli in the 15th century (the father of double-entry accounting system). Any analysis focusing on valuation should have such equation as the starting point and the focus ought to be on its four components (financial capital, financial return, operating capital and operating return).

Keywords

valuation; equities; investment; markets; investing; accounting; value investing; CROCI; capital; returns

The task of art today is to bring chaos into order.

Theodor Adorno

Chapter Outline

Outline

• The challenge of the real equity investors 1
• The fundamentals of equities investing: capital and returns 2
• The two sides of the investment process in an equation 4
• The many names associated with the components of the investment equation 4
• The many ways of presenting the investment equation 5
• The dark and the bright sides of valuation and how they drive price changes 6
• Modelling earnings into perpetuity and the relative challenges 8

The challenge of the real equity investors

Investing is challenging in any asset class, particularly for equities. Investors in fixed income have all the necessary information: price, valuation (the yield), the maturity of the bond and the credit rating of the issuer. For equity investors, there is certainly an abundance of information from brokers, the Internet and the media, but it is often difficult to make sense of such information.

At a fundamental level, the primary information includes the share price and the earnings released by companies, which provide the basis for multiple valuation metrics (dividend yield, free cash flow yield, EV/EBITDA, price-to-earnings ratio and price-to-book ratio), but investors tend to be unclear about which metric ought to be used and why. Additional complexity comes from (1) the absence of maturity for the investment unlike credit (the decision of when to sell is left with the investor), (2) the lack of a metric rating the quality of the asset (unlike credit) and (3) the investor’s need to choose between receiving a return in price or dividends (the first being very volatile and the second more stable, but with a permanent risk that it may be cut in the future). The challenge is even greater when one considers that prices are driven by two factors that can mutate over time, that is earnings and the discount rate.

Imagine instead a situation where you have an understanding of the valuation, how the business to which you are providing capital is financed (by debt holders or other providers of financial capital, such as pension and financial lessors), the capital invested in the business, the operational return the company generates on its business, and its true level of profitability. There is still uncertainty but this information would provide you with a sound basis for investment decisions. This is the nirvana of the real investor. Utopia? Not in my opinion. The secret is to focus on fundamentals and to think that when you are buying equities, you ought to run a process similar to when you are buying a company with your own money. Framing the process in such a manner has implications for (1) the time frame of the investment, (2) how one deals with noise from media and analysts and (3) your own analysis of share price dynamics.

I will share with the reader what a ‘real investment process’ looks like, by starting from first principles: capital and return.

The fundamentals of equities investing: capital and returns

The fundamental pillars of an investment process are capital and return. These core elements are valid for any kind of investment. In the world of equities, you find a separation between those providing capital, that is the investors (broadly defined as anyone providing financial capital) and those needing it (companies). Investors provide capital to companies and expect to be compensated by a return. Companies deploy financial capital in their operations, which will generate a return, used ultimately to reward the owners of financial capital.

The relationship between the investors and management is straightforward: the provision of financial capital is the monetary basis supporting the business. The company uses the financial capital in the business to invest in operations, stores, plants and machinery. The proceeds generate an operational return, which is used to reward the investor with a financial return that compensates for the risk taken. At a practical level, some of the financial return is distributed through dividends and some is retained by the business. The process can be simplified in the following manner (Fig. 1.1):

1. 1. The investor, who provides financial capital.
2. 2. The company that uses the financial capital and employs it in a business.
3. 3. The business generates an operational return.
4. 4. The operational return is the basis for providing the investor with a financial return, part of which is paid to the provider of financial capital and part reinvested in the business.

Figure 1.1 Capital and return.

This typology will be used throughout the book as I like to consider capital and return from the two different perspectives, the investor and the company. Thinking of a coin is a simple and effective way to think of the investment process. On one side, there are the financial investors and their return expectations, and management on the other, deploying capital to generate a return.

The duality of the investment process was formalised in the 15th century by a Franciscan friar, Luca Pacioli, in a book Summa de arithmetica, geometria. proportioni et proport...

Table of contents

• Cover image
• Title page
• Table of Contents
• Copyright
• Dedication
• Letter to the reader
• Foreword
• Preface
• Acknowledgements
• Introduction
• Chapter 1. Investment and valuation
• Section 1: CROCI on valuation
• Section 2: CROCI on investing
• Section 3: Through the looking glass
• Bibliography
• Index