Corporate Finance Topics | Q2 2013

Calibrating ROIC
to Drive Shareholder Value

We believe that driving shareholder value through optimizing return on

invested capital (ROIC) should be a consistent focus for corporate leaders.

As a follow-on to our Q1-2013 Corporate Finance Topics piece, 2013: The Year
to Challenge the Do Nothing Strategy?, we further explore the connection between
shareholder value creation and ROIC. In our prior piece, we noted that conservative
capital structures and large amounts of excess liquidity positioned corporates well
to execute on significant strategic or return of capital initiatives.
Considering a business as a portfolio of earning assets operating subsidiaries,
real estate, cash, etc. offers a helpful paradigm to consider value creation.
Each asset earns a return, which when combined, results in the businesss ROIC.
In this piece, we first highlight the importance of ROIC in determining shareholder
value over time. We then analyze the impact of excess cash on ROIC to show that
many corporates are holding cash in amounts that are well in excess of what our
data suggests is the optimum level to maximize shareholder value. Excess cash
has been in the spotlight for several years and continues to be in 2013, as
evidenced by a recent wave of activist focus driving capital structure realignment
and business reorganization. As part of our piece, we assess several characteristics
of corporates that may justify holding excess cash and note that the companies
that hold the most cash often do not exhibit these characteristics.

Executive Summary

1

1.

Total shareholder return is highly correlated to change in ROIC. Based on our

observation of S&P 500 companies1 performance over the past five years,
improvement in ROIC exhibits a strong correlation with total return. These
firms also tend to have the highest valuations, on a P/E basis, and lower
relative cash balances.

2.

Corporate cash balances remain elevated. We revisit the S&P 500 cash
accumulation charts that weve seen many times over the past several
years to reiterate that cash balances remain at historically high levels,
both on an absolute and relative basis.

3.

There are various corporate characteristics that may justify holding excess
cash. There are many potential reasons for management to build cash reserves.
Some of the most common rationales include: the need for growth capital,
high projected cash flow volatility, high fixed charges, limited access to capital
markets, and tax inefficiencies associated with repatriating offshore cash.

4.

However, companies with the highest cash balance often do not reflect these
characteristics. Typically, these companies hold a significantly larger multiple
of historical cash flow volatility, have lower gross debt levels and are able
to fund growth with operating cash flow and/or capital market access.

Data set includes 395 of the current S&P 500 constituents, with insurance companies, banks, broker dealers and REITs removed. Firms with
less than five years of trading history are also excluded. Analysis based on five years of data from January 1, 2008 through year end 2012.

Corporate Finance Topics, Q2 2013

5.

1
Total shareholder return
is highly correlated
to change in ROIC.

Consistently calibrating a portfolio of earning assets to drive ROIC is critical

to long-term value creation; and reducing the level of low-yielding cash on
the balance sheet is one of the simplest ways to improve ROIC. ROIC can
be enhanced by either (i) improving operating performance; or (ii) reducing
underperforming capital bases. A periodic review of all assets should be
performed that includes an analysis of separating subsidiaries, growth
initiatives and return of excess cash. Excess cash balances are arguably one of
the most underperforming capital bases; redeployment of excess cash towards
growth initiatives or return of capital can have a significant impact on ROIC.

When we looked across the various potential drivers of total return (ROE, EPS accretion,
ROIC, etc.), ROIC was the metric with the strongest correlation to total return.
We segmented the S&P 500 constituents2 into four quartiles based on annualized total
returns over the past five years and noticed a clear and very strong positive correlation
between total return and change in ROIC. As illustrated in Figure 1, the higher
the change in ROIC (1.5% for top quartile vs. -3.6% for bottom quartile), the higher
the annualized total return (15.8% for top quartile vs. -8.5% for bottom quartile).
We also noted that the companies with higher total returns generally had (i) lower
levels of cash as a percentage of market capitalization; (ii) similar or lower levels
of cash as a multiple of cash-flow volatility (as measured by two standard
deviations of cash flow); and (iii) higher P/E ratios.
20%

15%

1.5%

Five-Year Annual Total Return 2%

Five-Year Change in ROIC

15.8%

1%

0%

10%
(0.5)%
7.1%
5%

(1%)

(1.7)%
1.7%

0%

(2%)

(3%)

(5%)
(3.6)%
(8.5)%

(10%)

Figure 1. Five-Year Annualized

Total Return vs. Change
in ROIC Over Past Five Years

Cash/Market Cap

2

2nd Return
Quartile

3rd Return
Quartile

Bottom Return
Quartile

6.8%

6.9%

8.0%

13.0%

Cash/CFO Volatility (2 Sigma)

1.9x

1.4x

2.1x

2.0x

NTM P/E

15.4x

13.9x

13.3x

12.3x

Source: FactSet

Top Return
Quartile

Data set includes 395 of the current S&P 500 constituents, with insurance companies, banks, broker dealers and REITs removed. Firms
with less than five years of trading history are also excluded. Analysis based on five years of data from January 1, 2008 through year
end 2012. Quantities represent medians of each respective quartile.

Represents cash flow from operations.

Corporate Finance Topics, Q2 2013

(4%)

 2
Corporate cash balances
remain elevated.

We have consistently seen data that tells us cash balances are reaching all-time
highs. That continues to be true today, as illustrated in Figure 2. Cash balances
are not only high on an absolute basis, but are also high on a relative basis
(as a percentage of market capitalization). As compared to 2007, relative cash
balances at the end of 2012 were ~63% higher.
$1,400

S&P 500 Cash Balances (bn)

$1,176

$1,200
$983

$1,000
$800

$1,222

$1,102

$786

$734

$600
$400
$200
$0

2009

2010

2011

2012

$8.8

$7.1

$8.7

$9.7

$10.4

% of Market Cap

7.2%

8.9%

13.8%

12.7%

12.1%

11.7%

There are several reasons that may drive a corporate to hold excess cash,
and we have highlighted five in Figure 3.

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Hig

Common rationales
firms use to explain
high cash balances

Market Access

Debt and/or equity markets may

not be open when cash is needed

Figure 3. Reasons
for Holding Excess Cash
3

Corporate Finance Topics, Q2 2013

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ing u
high
s
gros ed to off
s lev
erag set
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3
There are various corporate
characteristics that may
justify holding excess cash.

2008

$10.2

Cash

Source: FactSet

2007
Market Cap ($bn)

hL
everag
e

Figure 2. S&P 500 Aggregate

Year-End Cash Balances

 4
However, companies with
the highest cash balance
often do not reflect
these characteristics.

We again segmented our S&P 500 data set into four quartiles, based on cash
as a percentage of market capitalization over the past five years, and then analyzed
whether a correlation existed between cash balances and the reasons we highlight
above. In Figure 4 we show that the companies in the two higher quartiles:
1.

Held the highest amount of cash as a multiple of cash flow volatility

(as measured by two standard deviations of cash flow)

2.

Had very similar cash requirements as the lower quartiles

3.

Had lower debt balances than the lower quartiles

25%

% Cash/Market Cap
21.6%

20%

15%

10.3%

10%

6.1%
5%
2.6%
0%

Top Cash
Quartile

2nd Cash
Quartile

3rd Cash
Quartile

Bottom Cash
Quartile

3.9x

2.3x

1.6x

0.7x

Agg 5yr (CapEx+M&A+R&D+Div)/

Agg 5yr CFO

100%

100%

97%

104%

Gross Debt/Enterprise Value

17.9%

14.4%

19.5%

23.0%

Cash/CFO Volatility (2 Sigma)

Figure 4. Five-Year Cash/Market

Capitalization Quartiles
Source: FactSet

With respect to market access, we analyzed debt issuances by BBB and BB

companies in the depths of the 20082009 financial crisis and note that there
were only two months without BB issuances (Sep 08 and Nov 08).
Finally, with respect to offshore cash balances, while its difficult to discern
the amount of cash held offshore by each of our constituents, there is certainly
evidence that many companies are accumulating significant offshore cash balances.
However, prudent capital management requires a continual assessment of breakeven economics vs. expected offshore cash usage. For example, if a company would
incur 15% incremental tax on repatriated cash but could earn a 7% return on that
cash for its shareholders (either by reinvesting in the business domestically or
returning capital to shareholders) vs. leaving the cash abroad and earning 1%,
the break-even period would be under three years. The probability of that cash
being put to better use abroad within that time period should be assessed, and
if the probability is low, the benefits of cash repatriation should be evaluated.
So while the quartiles we analyzed often do not exhibit many of the characteristics
that may justify holding excess cash, what they do show is a negative correlation
between the amount of cash held and (i) total return and (ii) P/E multiple as
illustrated in Figure 5.
4

Corporate Finance Topics, Q2 2013

7%

Annualized Total Return

NTM/PE

15.5x

6.6%

6%

5.4%

5%

4.7%

4%

13.8x

14.1x

13.5x
12.9x

2%

13.0x

1.4%

1%

12.5x
12.0x

0%

Top Cash
Quartile

Source: FactSet

2nd Cash
Quartile

3rd Cash
Quartile

Bottom Cash
Quartile

Companies with lower cash balances over the past five years generally performed
better (with the exception of the lowest quartile) on a total return basis over that
time period. There is a similar, but slightly weaker, correlation with cash balances
and P/E multiple; companies in our data set with lower cash balances generally
exhibited rising P/E multiples. Based on our data set, optimal cash balances can
be triangulated between cash as a percentage of market cap (5%7%) and cash
as a multiple of cash flow volatility (1.5x1.9x two standard deviations).

5
Reducing the level
of low-yielding cash
on the balance sheet
is one of the simplest
ways to improve ROIC.

In deconstructing ROIC, the two main drivers of improvement are:

1.

Increased operational performance for a given capital base; or

2.

Reduction of underperforming capital bases

ROIC =
1
2

(EBIT + Interest Income) (1 Tax Rate)

Average Capital Employed Excluding Goodwill
Operational Performance (EBIT)
Underperforming Capital (Low yielding assets)

Many corporates have made significant efficiency improvements over the last five
years with a commensurate increase in profit margins as they strive for earnings
growth. In addition to increasing profitability through operational efficiency and
increased asset utilization, in Figure 6, we consider four methods of achieving
ROIC improvement by focusing on high-performing assets in the portfolio.
Refocus on highest ROIC segments

Figure 6. Alternatives
for ROIC Improvement
5

14.5x
14.0x

13.6x

3%

Figure 5. NTM P/E and Five-Year

Annualized Total Return for Cash/
Market Capitalization Quartiles

15.0x

Sale

Spin-Off/
Split-Off

Growth
Initiatives

Excess
Cash

Sale of
subsidiaries
or assets with
lagging ROIC

Spin-off/split-off
of subsidiaries
with lagging ROIC

Capital
expenditures
and M&A focused
on highest ROIC
projects

Return excess cash

to shareholders
or invest in higher
ROIC businesses

Invest proceeds in
share repurchases,
or higher ROIC
businesses
Corporate Finance Topics, Q2 2013

High cash balances that primarily earn interest income over the medium to long term
are arguably one of the most underperforming capital bases. This has been further
exacerbated by all-time low interest earned on cash balances over the past few years.
The impact to ROIC of a reduction in cash for a hypothetical company in the top cash
quartile (as a percentage of market capitalization) indicates meaningful improvement
is achievable through a rebalancing of the capital structure.
In order to further examine what benefits cash reduction would generate for a top quartile
company, in Figure 7 we consider the impact to ROIC for a hypothetical company.

Hypothetical Company
Cash

$16.2

Market Cap

$75.0

Cash/Market Cap

21.6%

Total Capital

Significant ROIC improvement

possible while still maintaining
adequate cash cushions
to drive shareholder value

$50.0

EBIT

$5.0

ROIC

6.71%

ROIC Improvement from Cash Reduction4

Quartile

Cash Reduction

Cash/Market Cap

ROIC

% Improvement

21.6%

6.71%

Second

$9.4

10.3%

8.12%

21.04%

Third

12.4

6.1%

8.71%

29.72%

Bottom

14.6

2.6%

9.22%

37.36%

Top

Figure 7. Impact Upon ROIC

for a Hypothetical Company

Conclusion

As we look at the performance of individual corporations, it is clear that

consistently improving ROIC over time is a key driver of value. We note that
a companys portfolio of assets must be actively managed into perpetuity.
Consistent deployment of capital and ongoing reduction of underperforming
capital bases should form a permanent part of a companys strategy.

For more information,
please contact:

Souren Ouzounian
Head of Americas Corporate Finance
souren.ouzounian@baml.com
(646) 855-5300

Amir Mirza
amir.mirza@baml.com
(646) 855-4331

Jay Bliley
jay.bliley@baml.com
(646) 855-4666

Philip Turbin
philip.turbin@baml.com
(646) 855-4708

Leonard Chung
leonard.chung@baml.com
(310) 209-4062

Gus Garcia
g.garcia@baml.com
(646) 855-4680

6

Assumes total capital and market cap are reduced by the amount of cash reduction; ROIC calculations assume 1% pre-tax interest income
on cash and 35% tax rate.

Corporate Finance Topics, Q2 2013

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