CFROI: The HOLT Measure of Return on Capital

Learn what CFROI is, how it’s calculated, and why it’s a clearer and more consistent measure of performance than traditional accounting measures.

How can you tell which companies are the best performers to understand the halt methodology and fully appreciate its capabilities you need to understand cf roi the cash flow based return metric at the heart of halt in this tutorial you’ll learn what cf roi is how it’s calculated and why it’s a clearer and more consistent measure of performance than traditional

Accounting measures cf roi emphasizes a company’s cash generating ability by taking accounting information and converting it to cash cash flows generated from a firm’s activities are the best way to measure its underlying economics telling you whether a company is creating wealth or destroying it traditional accounting measures can obscure a firm’s true economic

Performance companies typically use highly subjective accounting methods making it difficult to draw comparisons between companies and sexes it’s also difficult to make comparisons across national borders because accounting standards can vary so widely by adjusting for these issues cf roi provides more clarity about a company’s true economics when companies make an

Acquisition or expand into a new business line they usually prepare an economic profile for capital budgeting purposes the profile forecasts all cash outflows and inflows over the estimated project life an internal rate of return can then be calculated and is a proxy for the project’s economic return let’s imagine we’re starting a freight delivery company our first

Project is purchasing a truck to make deliveries we pay $25,000 once the truck is in service the deliveries it makes produce five thousand dollars of operating cash flow each year at the end of five years we can sell the truck for ten thousand dollars based on these figures the trucks return on investment or internal rate of return is ten percent now let’s assume

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We expand our operations with the purchase of the plane we pay a hundred thousand dollars for the plane the deliveries it makes produce ten thousand dollars of cash flow each year after 20 years we sell the plane for twenty five thousand dollars as a result the planes irr is 8% let’s look at a real logistics and delivery company fedex as an example if we use actual

Figures from 2008 we see fedex is a complex company with a combination of many ongoing projects similar to the calculation of a single projects return on investment cf roi is an approximate irr of all the projects of the business cf roi translates the ratio between investments and cash flows into an internal rate of return by recognizing the finite economic life

Of assets that depreciate such as buildings and the residual value of assets that don’t necessarily depreciate such as land and cash the cf roi is a proxy for the company’s average economic return on all of its projects in a given year this is similar to how a firm’s income statement and balance sheet are a snapshot of financial performance once you understand

Cf roi you can start viewing it through time to see whether a company has used its resources effectively to generate wealth in the past you can also compare cf roi levels between companies fedex and ups for example are in the same business but they manage their assets very differently traditional accounting measures of performance don’t include these off-balance

Sheet leases in their calculations by placing these leases back on the balance sheet we remove the distorting effects of different financing choices leading to a more accurate comparison the modified balance sheet indicates that ups earns a higher return on capital than fedex the cf roi metric also overcomes comparability issues amongst countries with different

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Accounting standards as with a fedex and ups example hult users can feel confident knowing that the cfr a metric allows for comparisons around the world we can compare fedex and a competing company uk mail group to see whether a company is actually creating economic wealth we need to compare the cf roi level to the company’s cost of capital which is also called

The company’s discount rate firms earning above their cost of capital create economic wealth so they should strive to grow at high returns as fast as possible returns below the cost of capital destroy wealth firms in this position should focus on increasing their cf roi and reducing underperforming assets rather than on growth when a firm’s returns are equal to

The cost of capital management should focus on increasing cfr why incremental investment creates no value these wealth creation principles and their relation to shareholder value creation come to life when we combine the history of fedex’s returns relative to the cost of capital the growth of the company’s asset base and the stock price performance this tells us

Where the management has been reinvesting in the business whether those investments have created value and if the market has responded we do this in the relative wealth shot between 1993 and 2000 fedex is cf roi levels were consistently below its cost of capital yet the company continued to grow aggressively this destroyed shareholder value between 2001 and 2005

Management’s strategy changed fedex’s cf roi level gradually increased to a point where it exceeded the cost of capital this was followed by asset growth creating wealth for shareholders unfortunately the company couldn’t sustain the asset growth strategy fedexes returns fell below its cost of capital causing the stock performance to suffer in the valuation tutorial

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Will show you how cf roi is used in the halt discounted cash flow model and how you can use the relative wealth chart to objectively compare the markets expectations holes perspective and your own view you

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CFROI: The HOLT Measure of Return on Capital By Credit Suisse