US public companies have improved capital return spread. Between the dot-com bubble and the financial crisis, the return on capital was not trending upwards and EVA spread was not positive. Incremental return from capital investment in this period is estimated to be around the cost of capital.
After the financial crisis, the return of capital moved higher, and EVA spread increased up to 3% and then came off due partly to the weak energy and commodity materials.
Meanwhile, enterprise and equity valuation against free cash flow became attractive. FCFF/EV yield increased to over 5% in 2009. It went down less than 4% and became less inexpensive, but it is still above the peak of from 1995 until 2007. The downward trend of this yield multiple reflects the gap of the growth rate of FCFF and the market price increase of EV. Cyclical commodity industry is expected to return to growth and contribute to FCF growth.
To be fair, the return on capital has made a round trip and back to where it was in 20 years ago. The increase in EVA spread has come from the decline in the cost of debt. It was down nearly 4%. It is safe to assume that the cost of debt has an asymmetrical probability distribution in the future given the limit to the downside, given the gradual recovery and the confirmed adverse impact from near-zero rate environment. EVA spread in the next decade will get impacted by it.
As discussed, the risk-free rate has been trending downward – but the US is holding steady around 2%, showing a sign of the upward move. Both EU and Japan are still around the ground level, but it is not likely to take the same path they had in the last decade unless both central banks can accept the risks of hurting financial service companies especially banks.
At the same time, all the three central banks have now the same level of total assets. USD 13.5 trillion is almost 2x bigger than in 2010. The changes in natural growth rate and demographics would force them to adopt a new financial model of the central bank and may keep the current structure. However, this has just started, and the model has not yet established, and the outcome is not predictable with a high level of certainty. Moreover, its impact will be felt through many routes, including the economic profit of the corporates as well as the FCFF yield spread.
Interest Rate, Cost of Capital, Return on Capital Invested