Equity Valuation: Models from Leading Investment Banks

11

From Accounting to Economics: CFROI

11.1 THE BASICS

In order to understand the logic and benefits of the CFROI calculation, let us imagine a simple investment scenario. Suppose you invested $1m in your cousin Greg's home refurbishment business. He asks for an eight-year investment with $800 000 to support the shop and its fittings, and $200 000 for working capital. The shop equipment and fittings are depreciating assets that will need to be replaced after eight years. The working capital will purchase inventory and allow for day-to-day management of the business. You are the sole investor in this business and Greg's salary is an operating expense. He boldly promises that the business will generate a return of greater than 20%.

Since your cousin is a trustworthy character, you leave him to run the business and attend to your other investments. You receive a check for $200 000 every year, which is a 20% return on your original investment. After five years, you decide to pay Greg a visit and check on your investment. When you arrive at his shop, the business seems to be going very well and Greg tells you he expects the business to break through the 20% return barrier.

Greg apologizes for the slow start but confidently tells you that the business earned 20% last year and shows you his forward estimates of the return on net assets (RONA) with returns increasing to 50% (see Table 11.1). After pondering his apology and scratching your head over his rather astounding forecast, you attempt ...