Interest rates, WACC and Capital Allocation

Interest rates, WACC and Capital Allocation

Author: Joris Kersten, MSc

Kersten Corporate Finance: M&A advisory @ The Netherlands. www.kerstencf.nl

5 day Business Valuation training, 4th – 8th November 2024 Amsterdam. www.joriskersten.nl

Source used: Morgan Stanley Investment Management, Counterpoint Global Insights, Cost of Capital and Capital Allocation – Investment in the era of easy money. February 2024. Michael J. Mauboussin & Dan Callahan.

?

Introduction

From 2009 financial capital was cheap and abundant.

The FED and other central banks around the world reduced policy rates to essentially zero, until 2021.

We can examine two periods of equal duration:

·?????? The phase of “easy money”: 2009 – 2021;

·?????? The 13 years preceding it: 1996 – 2008.

The average yield on the 10 year US treasury note was 2.3% from 2009 – 2021. Versus 5.0% from 1996 – 2008.

All else equal, declining interest rates are good for asset prices. Because future cashflows are worth more when discounted back at a lower rate.

The CAGR (compound annual growth rate) for the S&P 500 (index of the largest public companies in the US) was 16% when there was easy money (2009 – 2021).

And 4.8% CAGR the equal time before (1996 – 2008).

This in the form of “total shareholder return”, both due to “earnings growth” and expansion in the P/E multiples (capital gain) as a logical outcome of lower interest.

The returns in the easy money era were exceptional, cause the CAGR for the S&P 500 was 9.6% from 1928 – 2023. ?

But lower interest rates, and ready access to capital, would suggest that companies invest more. And that they use more debt, and hold less cash.

More abundant investment opportunities would also imply restraint from returning cash to shareholders.

But that is really not what companies did ! Let’s find out how this works !

WACC

It was estimated that the WACC for companies in the Russell 3000 dropped to 6.9% avg in the time of easy money (2009 – 2021).

This from 7.5% avg in the time before (1996 – 2008), based on annual averages.

Companies should ideally rank their investment opportunities and pursue those that pass the NPV test (net present value test).

Basically, taking up projects with a higher return than the WACC.

A lower WACC during 2009 – 2021 boosts the future cash flows, and therefore allows more investments to clear the “hurdle”.

A logical consequence is an increase in investment opportunity.

But, the WACC is not what most companies use to discount cash flows.

About 80% of companies adopt a “hurdle rate” that is substantially higher than their WACC.

In the time of easy money, researchers estimate (see the source I used for this blog) that the average “hurdle rate” used was 16.8%.

This is more than double the average perceived WACC !!

Reason for this could be that:

·?????? Executive are conservative;

·?????? "Sticky hurdle rates” are not adjusted frequently;

·?????? Serves are cushion for (too much) optimism.

?

ROIC and the ROIC/ WACC spread

Companies made a ROIC of 9.5% avg during 2009 – 2021 with a WACC of 6.9% avg.

And they made a ROIC of 9.2% avg during 1996 – 2008 with a WACC of 7.5% avg.

So they made a ROIC of about 50% – 60% of the hurdle rate they use.

So a lot of investments fail to earn the hurdle rate !

Still they manage to earn a positive ROIC/ WACC spread of 2.6% avg (2009 – 2021).

And a ROIC/ WACC spread of 1.7% avg (1996 – 2008).

?

CAPEX

Companies largely rely on the cash their companies make to fund their investments.

These investments can be internal, like CAPEX, working capital, R&D and intangible investments through selling, general and administrative expenses (SG&A) (basically NOT capitalising SG&A, intangible investments seen as expenses).

And these investments can be external, like M&As.

Investments, including CAPEX, M&A, R&D and non R&D SG&A, as a percentage of sales were:

·?????? 24.5% avg during 2009 – 2021;

·?????? 27.3% avg during 1996 – 2008.

This is counter intuitive to that lower interest rates lead to a higher investment activity.

These reflect total spending on these investments, but it is common to break up investments into “growth” & “maintenance” investments.

Proxies for maintenance investments include D&A (depreciation & amortization).

But the decline from “growth investments” from 12.7% to 9.5% was similar to the overall pattern mentioned above.

Partial conclusion:

Despite lower WACCs in 2009 – 2021, compared to 1996 – 2008, companies invested at a slower rate, and the ROIC/ WACC spread widened !

Aggregate IC (invested capital) grew at a 2.6% CAGR from 2009 - 2021, and 4.9% from 1996 – 2008.

Reasons for this could be:

·?????? Decreased competition;

·?????? Heightened governance.

?

Capital structure

Companies tend to settle their capital structure with less debt than (theoretically) ideal.

This because they are conservative.

The “debt to total capital ratio” for the Russell 3000, excluding financials and real estate, was in aggregate from 1996 – 2021:

·?????? Average 21.6% from 2009 – 2021;

·?????? Average 32.7% from 1996 – 2008.

Total capital is defined as the book value of debt + the market value of equity.

Also the “interest coverage ratio” (operating income over interest expense) went up from 5.5 times to 7.9 times.

This “de-leveraging” in a lower interest era is counterintuitive.

Also interest on excess cash is less, but also excess cash and marketable securities increased as a percentage of total assets.

This also is counterintuitive.

(“excess” is seen as anything above 2% of sales)

Partial conclusion:

Companies place much higher emphasis on “financial flexibility” than on “interest rates” when deciding on their capital structure.

So they are conservative on both their capital structure, and level of excess cash.

The overall picture suggests that prevailing interest rates were not central to the choices executives made.

?

Share buybacks

The total shareholder yield; dividends + buybacks (net of equity issuance), divided by “market cap” rose to 3.8% on average from 2009 – 2021.

This from 2.6% on average from 1996 – 2008.

And buybacks were higher during 2009 - 2021.

Research shows that executives make financial decisions that stay away from ideal long term value creation for shareholders.

Instead they focus on maximising earning per share (EPS).

And the era of easy money (2009 – 2021) made buyback particularly effective for boosting EPS.

Another reason for it was offsetting the “dilution of EPS” from SBC (stock based compensation).

?

I hope this was helpful.

See you next week again with a new blog on Corporate Finance !

Best regards, Joris

?

Source used: Morgan Stanley Investment Management, Counterpoint Global Insights, Cost of Capital and Capital Allocation – Investment in the era of easy money. February 2024. Michael J. Mauboussin & Dan Callahan.