One Number That Won't Lie
If you want to understand what's really going on behind the headlines, follow the return on capital.
FORTUNE
Monday, January 21, 2002
By Geoffrey Colvin
Political journalists have a saying that rarely leads them astray when they're trying to get to the bottom of a complicated story: Follow the money. In business journalism we're more specialized. Our mantra is--or ought to be--follow the capital. Right now, as always, that's the best way to understand what's really going on behind some of the biggest stories around.
The fact is that most of us, readers as well as writers, don't follow the capital nearly as doggedly as we should. We get seduced by other angles--technology advances, corporate politics, marketing campaigns, market share battles. They're all important and definitely fun to read about, but they're not how the score is kept. Besides, focusing on capital takes one into the realm of corporate finance, and a lot of people, including a shocking number of CEOs and board members, never took Finance 101. But anyone can understand that business success is ultimately about earning more money than your capital costs. With that in mind, take a fresh look at some of today's most important business stories.
The Hewlett-Packard/Compaq deal. Why did investors despise this deal from the minute it was announced in early September? In the business of personal computers, servers, and storage, both companies are getting kicked around by Dell. Their deal rationale was that together they could beat the bully.
But look at the capital. HP and Compaq have similar costs of capital, about 11%. Their returns on capital are each below that, which means ultimately they're failing. By combining, could they find efficiencies and new revenues that would push their return on capital above 11%? Possibly, though some analysts doubt it. Then look at Dell: Its return on capital is 46%. Now if HP and Compaq were to merge and nudge the return up above 11%, do you suppose Dell, from its superior position, might find a way to pound that return back down while maintaining its own return far above its capital cost? That's why investors hate the deal.
The Enron debacle. As Enron's stock spiraled up into the 70s and 80s in the wacky days of Net mania, investors focused on many factors: the huge popularity of Enron Online, the company's ability to securitize almost anything, from broadband capacity to weather, the stream of hotshot MBAs to Houston. What they apparently didn't focus on was capital. Perhaps the most remarkable fact about Enron in retrospect is that even in its glory days--when the stock was near $90, and CEO Jeff Skilling was arguing that it should be at $126--the company was not earning its cost of capital. Its return was a stunningly low 6% to 7%--and that doesn't reflect the capital we've since learned Enron was keeping off its balance sheet through financial sleight of hand. The real return was even lower.
But couldn't investors have been looking ahead to better returns down the road? Some companies, especially fast-growing young ones, hold a realistic promise of dramatically higher future returns, which can justify a seemingly high stock price. But Enron was no startup. It was No. 7 on the Fortune 500. Back when its stock was in the stratosphere, a simple glance at the return on capital would have told anyone trouble was ahead--even before we knew about the financial shenanigans.
The SEC's attack on Ebitda. When the Securities and Exchange Commission warned investors in December to view any company's "pro forma" financial statements with "healthy skepticism," it advised them to "be particularly wary" of Ebitda--earnings before interest, taxes, depreciation, and amortization. Excellent advice. "Pro forma" is an official-sounding Latin phrase that means "earnings the way we like 'em," as distinct from earnings stated in accordance with accounting rules. What's so insidious about Ebitda--a pro forma measure favored by many companies, including AT&T, Hughes Communications, and AOL Time Warner (parent of FORTUNE's publisher)--is that it states earnings so as to leave capital's good effects in place while stripping the bad effects away completely.
For example, when a company takes on capital by borrowing money, Ebitda will report any return the company might earn on that capital but will exclude its cost--the interest. If the company buys another company, say, by issuing new shares, Ebitda will report the new profits but won't mention the depreciation and amortization that necessarily come with them. And while depreciation and amortization are very, very far from perfect as a measure of capital costs, you have to admit that ignoring them is bizarrely one-sided. It's as if a football team issued an excited press release announcing it scored 21 points on Sunday--without mentioning what the other team scored.
Our economic system isn't called gross-marginism or market-shareism or Ebitdaism. It's capitalism. As we read (and write) the financial news of the coming year, let's resolve not to forget that.
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