Key Performance Indicators - Basics

Have you ever had a friend ask, "Do you think $XYZ stock would be a good purchase?" It takes awhile to know a company on the level you'd be willing to invest. Most people would believe a full DCF (discounted cash flow) analysis is the best way to come to a decision on intrinsic value. I will quickly make the argument that there are good and bad companies that represent good value based on markets mis-pricing them; context matters. A second quick point is: working backwards from price to cash flow expectations may be a better way of finding opportunities.

The purpose of this post however is to set aside common beliefs about key performance indicators. The most common answer you will get if you asked 100 people a quick way to value a company would be the Price to Earnings (P/E) ratio. It is front and center for investors on all websites displaying stock key performance indicators (KPIs), but the P/E ratio does not tell the entire story by itself for multiple reasons including (1) capital structure, (2) a plan for shareholder returns, (3) growth, and (4) ROIC among others. I will outline each of these I find important below:

  1. Capital Structure

The table below demonstrates two companies with different structure; one used debt to fund half the company. I introduce the concept of (1) Enterprise value (EV) which takes into account total capital (equity + debt - cash) and (2) NOPAT (Net Operative Profit after Taxes) as a method for looking at earnings with the effects of debt eliminated.

Now lets summarize:
- They make the same amount $ wise, and they have the same enterprise values.
- NOPAT is calculated using the EBIT value * (1 - tax rate). This simply eliminates debt expenses and tax benefits based on debt. Some websites use EV/EBIT which is the same but before taxes. EV / NOPAT (or EV/EBIT) shows you that these companies are equally effective operators, with all capital considered.
- When looking at two companies and trying to determine which is more efficient at generating income EV/NOPAT would be a better measure because it eliminates the capital structure differences.

2. Shareholder returns (distributions), 3. Growth, and 4. Return on Invested Capital (ROIC)
It is acknowledged that the following equation (Gordon Growth Model) can be used to value a company with constantly growing dividends in perpetuity. We will use it here for simplicity (saying all distributions are dividends).

Company value = distributions / (r - g).
distributions are dividends (and in our case buybacks, and debt paid down).
r is the cost of capital (WACC) or returns required (opportunity cost)
g is growth of dividend (buybacks, and debt paid down)

I present these three together as the important takeaway here is that distributions and growth are correlated, and the connection is based on ROIC.

Looking just at P/E, EV/EBIT, or EV/NOPAT is only a snapshot in time. Two companies could have the same values, one decaying from a former peak, and the other increasing its earnings moving forward. Growth matters. But if you sacrifice distributions for growth you will not increase value. Thus, ROIC matters also. A higher ROIC means you sacrifice less distributions to get the same return.

Value = distributions / (r - g)
Companies both make $1. Cost of capital is 10% for both. Both companies are pushing for 5% growth per year. Company A has ROIC of 20%. Company B has ROIC of 10%
Company A value = .75 / (.10 - .05)
Company B value = .50 / (.10 - .05)
It takes much less of an investment (sacrifice from distributions) to get the same growth when you have higher ROIC.

Your ROIC must also be higher than the cost of capital to make money. If your cost of capital is higher than ROIC you will lose money, and the more growth you have the more you accelerate the losses.

In summary, as I screen for a mature company I would look at EV/EBIT (before tax) or EV/NOPAT (after tax). Then, review growth, ROIC (vs cost of capital), and distributions.

Next, review its main competitors (better to look at median data than mean if looking at combined data). Do not compare EV/EBIT or EV/NOPAT alone. Compare the whole picture (all 4 variables). One company may have PE of 10 and be the same value as a company with PE of 20, depending on the other variables.

This would be a very superficial look at a company; but more useful than saying "The P/E ratio makes this stock looks cheap".

Paul Weaver

Charlotte, NC