|Author:||HOLT Value Associates|
|Used For:||Accounting, Financial Management, KPIs|
It is not easy for potential investors to draw any significant conclusions about the health of a company based purely on accounting earnings. Accounting data can sometimes be misleading and so cannot be completely relied upon to give a realistic picture of the economic value and cash flow of a company. Thus an alternative method is required. Cash Flow Return on Investment (CFROI) provides a solution. Developed by HOLT Value Associates, CFROI allows investors to delve into the internal economics of a company in order to find out how cash is created, how operations are financed, how capital providers are reimbursed without relying on the company’s financial statements. Furthermore, CFROI is a very useful metric because it also takes into account the effects of inflation.
How Cash Flow Return on Investment Works
CFROI is a valuation model that assumes that the stock market determines prices based on cash flow, not on a company’s earnings or corporate performance.
For the company, CFROI is essentially the internal rate of return (IRR). CFROI is compared to the hurdle rate in order to determine whether or not the investment/product is performing well. CFROI must exceed the hurdle rate in order to satisfy an investor’s expected return.
CFROI is usually calculated on an annual basis. It may be calculated at the divisional or strategic business unit (SBU) level, as well as for private held companies. The high-level formula for determining CFROI is the following:
In order to calculate CFROI, the following information needs to be determined:
- Cash Flow: Gross cash flow of the company adjusted for inflation as well as non-cash expenses.
- Present Value: The gross investment into the company. This should be adjusted for inflation.
- Project Life: The company’s gross asset life estimated via depreciation expense as well as total depreciating assets
- Future Value: The company’s non-depreciating assets
The above information will then be used to solve for IRR (CFROI). Further details of the CFROI calculation may be found in the book CFROI Valuation, by Bartley J. Madden.
Finally, CFSB HOLT maintains a database of CFROI’s for over 18,000 companies worldwide. Historical records of up to 20 years are maintained for U.S. companies and up to 10 years for non-U.S. companies.
Other Readers Also Read:
- Cash Flow from Operations
- Cash Ratio
- Current Ratio
- Dividend Payout Ratio
- Earnings Before Interest and Taxes
- Earnings Before Interest Taxes Depreciation and Amortization
- Economic Value Added
- Market Value Added
- Relative Value of Growth
- Return on Equity
- Total Shareholder Return