The Cost Of Capital; Follow the punishing regime and money men will

WHERE once investor presentations used to focus on the impact of organic growth or shrinkage, or acquisitions or disposals on earnings per share, fund managers now want to know about the degree to which companies exceed or fall behind their cost of capital. It is a far more punishing regime, less open to accounting manipulation and thus a far more suitable measure for investors.

Francois Langlade-Demoyen, partner at Buttonwood Capital, says: "You can look at different financial criteria but at the end of the day it is important to see how much a company returns in relation to its capital. Anybody who runs a grocery store knows that."

Many factors will determine whether a company is improving. But anyone looking for clues should look at the numbers in the table for last year's SVA. This measure takes the after-tax operating profit for each company and compares it with its cost of capital.

The cost of capital includes the cost of equity; what shareholders have a reasonable expectation of receiving through capital gains and dividends, as well as the cost of servicing its bank loans and other borrowings. For each company the cost of capital varies, sometimes quite widely, for two main reasons.

Some industries are naturally riskier than others - investors in a brewer will accept lower returns than investors in a young software developer because the brewer is likely to generate stable returns, while the software developer may stumble. Different firms have different capital structures; some have lots of equity, which is expensive, while others have lots more debt (usually cheaper).

In the rankings (left), both Inveresk and Sportech have low costs of capital - below 4.8% - which gives them lower "hurdle rates". But Aortech, Orbital and Cairn Energy have costs of capital of more than 13.5%, reflecting the perceived risk of the sectors in which they operate.

The SVA figures represent the difference between profit and the cost of capital. The theory is that it is not good enough for a company just to make a profit from its business. It also has to make sufficient profit to justify the cost of its capital, including equity. If it is not covering its cost of capital, then the logical conclusion is that investors' would have been better off to have placed their money elsewhere.

The cost of capital is the "opportunity cost" of funds to an organisation. Seen from the perspective of the providers of those funds, this equates to their required rate of return. Companies may have more than one source of financing, in which case the cost of capital has to reflect in some way the breadth of different interests.

John Wallace

Copyright 2001
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