A note from me

Hi Folks,

Renewal is a strong theme in this Newsletter’s personal note.  

I am writing this while pretty exhausted after a weekend travelling to the UK and back to the Netherlands to spend time with longstanding friends and to meet up with my grandson to attend Everton’s first competitive game at the new stadium.  Aaron and I arrived early for the game to have a good look around at all the different facilities and refreshment options at the stadium.  The new ground is, frankly, awesome and a tribute to good design driven by thoughtful purpose for a “people’s club” dating back to 1878, with a history of playing at the much-loved Goodison Park stadium for the past 133 years.  Here we are taking a selfie before the crowds really arrive.

Goodison was renowned for the great atmosphere generated by the crowd, but there was a clear need for facilities suitable for the modern day and looking to the future.  The new ground at Bramley-Moore Dock brings that, but has also been designed to retain that wonderful atmosphere with all fans feeling close to the action.  Here is a view from our seats just a few minutes before kick-off.

And Everton won this first game!!!!!  What an exuberant and joyful occasion!

The previous day had got off to a difficult start as my plane flight was cancelled with little notice, but I was able to find an alternative to a different city and re-jig all travel arrangements.  So I arrived a little flustered in the home town where I lived during my school days to spend the afternoon with my longest-standing friend from that time and his wife.  

The last time I had walked around the town was some 25 years ago, when it had fallen into a pretty sad state.  I was worried that I’d find further decline, as 5 years ago, I visited a different local town and was shocked by the state of it.  However, I was delighted to find that Chorley has definitely turned a corner.  There has been much positive renewal, though, as always, there’s more to be done.  This must again speak to thoughtful, purpose-driven planning and investment in contrast to what has been happening in those other localities.

My friends, Tony and Jac, walked me around the centre, then suggested a lovely walk up and around the “Nab” – the big hill behind the town.  They are obviously fitter and more used to such hikes than I am.  The walk was both interesting and beautiful, but after 3 and a half hours, I was definitely in need of cold beer and a sit-down!!!  They had to help me over a few of the stiles along the way, and I am still stiff as I write!

This is a reminder that, of course, we get older every day.  I am navigating retirement from corporate executive life and trying to renew my approaches and contributions to promoting better lives for people with a healthy planet. The world - and all families - face the challenges of renewal.  If you look at the first photograph, Aaron is just beginning to enter the prime of his life, while I guess I am close to the end of mine.  In my head, it doesn’t seem long ago that I was taking him to his first Everton game (see photo below), but it actually is, and he is now as tall as the life-size image of Big Dunc in the photo.  

This Newsletter may again feel like a bit of a harder slog than typical editions, with its inclusion of financial terms and charts, but I hope you find reading it a valuable experience.  It continues to build on threads we have explored previously, aimed at helping you build a better life for yourself and the people around you, despite the current socio-political challenges and disruptions across the world and your own personal challenges.  I hope you continue to find all these Newsletters valuable and that they help you enrich your own personal or organisational perspectives. 

I also hope that we are all able to renew ourselves positively and that we will collectively be able to pass on a decent world to those, like Aaron, who are inheriting it.

My Bi-Weekly Guide

Making Good Money – Value Ratio Analysis (and Art)

As explored in the previous Newsletter, the Value Ratio is a helpful tool for considering whether businesses are generating value in financial terms.  This is the ratio of Enterprise Value (EV) to Capital Employed (CE).  In this Newsletter, we will dig a little deeper into this ratio.  

The focus on financial value is important as this is one of the ways we assess overall value generation, knowing that the commercial engine is one of the most powerful shapers of our world.  Equally, we also know that there are other characteristics of value that are significant and yet less susceptible to financial metrics, such as aesthetic, emotional and spiritual value.  The notion that we must balance our attention between financial and other values is a regular artistic theme, as portrayed in the painting “The Money-changer and his Wife” by Quentin Metsys from Antwerp, painted in 1514.

This is a beautifully rich work in which the artist demonstrates his dexterity through the wide variety of details he portrays so effectively – people, fabrics, glass, coins, pearls and a convex mirror.  It can be found in the Louvre gallery.

The painting was made when the Low Countries were at the heart of international trade, so all forms of currency were also being used and traded.  Money changing was an important profession.  The painting both suggests the care that is needed to do this properly, but also the danger that the focus on money can distract attention from other important matters.  For example, the wife has been distracted away from her book of prayers, and the window in the convex mirror, with its prominent cross-shape, is a reminder that there is a bigger world and reality beyond this business.   

In the 17th century, a quotation was added to the frame of the painting, reading "You shall have proper scales and proper weight stones”.  This is a clear message to the viewer to bear in mind the just and responsible use of money.

Digging into these kinds of details can be very helpful in deepening our appreciation of a work of art, and, in that spirit, we will now dig a little deeper into the value ratio!

5 Lessons from the Value Ratio:

1. Deconstructing the Value Ratio:

   
   EV/CE can also be written as EV/Earnings multiplied by Earnings/CE.
   
   Earnings/CE is generally referred to as “Return on Capital Employed” or ROCE.
   
   For most businesses, the Enterprise Value (EV) is mainly made up of the market value (MV) of the equity in the company, which is generally much more significant than the value of its debt.  So EV/Earnings is roughly MV/Earnings and tracks this indicator.  MV is made up of the value of all the shares in the company, so MV/Earnings equates to the price/earnings ratio indicator of the shares, or P/E.
   
   So the Value Ratio can be approximated as the Return on Capital Employed multiplied by the price/earnings ratio, or ROCE x P/E
   

2. Return on Capital Employed:

   
   ROCE is a much-used accounting metric to indicate the performance of a business.  It indicates the current earnings that are being generated from the capital historically invested in the business, and so, gives a perspective on the capital efficiency of the business and how it is performing relative to competitors.  A high ROCE is generally a positive indicator.  However, because capital is depreciated in accounts over time, it is a measure that is really only useful for businesses that are being sustainably invested in to continue operating.  If a business is being run down, the Capital employed will trend to zero, and the ROCE will trend to infinity, but that will not be a valuable indicator of excellent performance!
   
   While the ROCE (also sometimes referred to as return on invested capital) can be calculated from a company’s accounts, it is affected by factors such as inflation, the accounting treatment of depreciation, investment profiles and the discount rate applied historically in justifying investments in a sector.  Market averages (e.g. for the S&P 500) have typically been around 12%.  Looking at the cloud of results from various businesses I have considered in the past, my “rule of thumb” was that an average company ROCE is generally around the real terms discount rate + inflation + 2-3%, with outstanding ROCE around 2-3% above that. Over the past 30 years, with a discount rate of around 7% and inflation around 3%, this would also suggest an average ROCE around 12% (and a benchmark for outstanding being 15%). 
   

3. Price/Earnings Ratio:

   
   The current market value (MV) of a company is an indicator of what investors believe its future earnings could be, discounted by a factor to take into account the time before such earnings may be distributed to the investors.  So it is an indicator looking from today forward, whereas ROCE is looking from today backwards.  The P/E ratio is looking at the sum of discounted future earnings compared to the current earnings.  A high P/E indicates that investors believe there will be good growth in earnings from today’s level.
   
   Taking a very simplistic view for a first approximation – if a company could sustain its current earnings forever and these were discounted back to today using a single discount rate (r), then the MV would be the current earnings divided by the discount rate, and the P/E ratio would be 1/r.  With a real terms discount rate of around 7%, this would give a typical P/E of 14.  The long-term market average is actually around 20, suggesting that investors typically see some earnings growth opportunities for the successful companies that do not drop out of the market.  Outstanding values are around 25-30.
   

4. Combinations of ROCE and P/E:

   
   Taking the typical average values noted above, a typical ROCE x P/E would be 0.12 x 14, which is 1.7.  This is a little higher than the “around 1” average value for the Value Ratio in competitive circumstances that I asserted in the previous Newsletter, but it is in the same ballpark.  In addition, given that some companies fail, this would push full averages for these two mathematical approaches closer together.  

   For reference, here are current values for a couple of the companies in the industry I used to work in (integrated energy).  The deconstructed proxy for estimating the value ratio delivers similar results to the direct calculation of the ratio.

Both companies have a ratio somewhat above 1, indicating that both companies are generating value in excess of the capital invested in them.  Looking at the individual factors in the deconstructed approach, it appears that the financial market anticipates future earnings growth to be much higher for Chevron than Exxon, while its current capital efficiency is slightly lower.  This may be because Chevron is currently able to invest in assets for future growth that have yet to come onstream.   

The deconstructed approach is helpful as it stimulates careful looking forward and backwards at business performance, and that can furnish additional insights.

For example, I am a novice in looking in detail at the “Tech Sector”, but here are the current relevant figures for some of the high-profile companies.

All of these companies are generating value hugely in excess of the capital invested in them – just compare the figures with the energy companies given above – and the deconstructed proxy approach to estimating the value ratio, while not perfect, isn’t bad.  More interestingly, looking ahead, the markets estimate similarly high earnings growth for all these companies, while their current capital efficiencies are quite different.  All of them are generating returns on capital much higher than typical companies, but Apple, in particular, appears to have a structure and competitive strongholds that are generating phenomenal income without particularly high levels of investment.  I guess we will all have views on how their products, platforms, and business ecosystems are driving their success in value generation.

5. Drivers of the Value Ratio:

   
   By decomposing the value ratio into two factors, more insights can be generated into building financial value.
   • Return on Capital Employed (ROCE) captures how efficiently current earnings are being generated from past investments.
   • Price-to-Earnings ratio (P/E) reflects the market’s view of future opportunity; how much growth investors expect, and how confident they are in the company’s ability to deliver it.
   
   A high value-ratio, therefore, implies a business that performs well today but is also positioned to grow, sustainably and competitively, into tomorrow.  
   
   This framing is particularly relevant in the energy space, where both past investments and future expectations are under intense scrutiny.

In summary, this Newsletter has taken a deeper dive into understanding the underlying drivers of the value ratio.  Our next Newsletter will take a closer look at the next factor identified in our first edition on “Making Good Money”, and that is good growth.

Please note: 

The arguments presented in this Newsletter are not providing investment advice and suggesting that you will generally find good investments for your funds wherever you find a high value ratio (with underlying higher than average ROCE and/or higher than average P/E).  Such a high ratio, however, is a signal that a company has been able to generate competitive strongholds of some kind.  If you are able to identify the nature of these and subsequently conclude that they are sustainable and expandable, then that may become an indicator of a potentially attractive opportunity.  

Question of The Fortnight

Every fortnight, I’ll be asking a thought-provoking question in hopes of sparking interesting and enlightening discussion.

I’d love to hear your response! You can do so by simply responding to this email.

Today’s question is:

Do you find this attention to the value ratio illuminating or confusing?

The Dodo Club Online Course

If you would like to learn more about the kinds of topics covered in these Newsletters, then please consider signing up for the introductory online course.

This covers scenario/systems thinking for grappling with uncertainty, an introduction to energy transitions, and the development of strategic character in leadership.

In the interest of avoiding the fate of that unfortunate bird, the Dodo, this course aims to help us secure our own personal legacies within a changing world and the energy transition - and to leave a healthier planet for future generations.

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A series of follow-up courses that treat the main topics in increasing depth and detail will be provided if there is sufficient interest.