Yes, PDN, it was my thought that "post audits" should be used on any major capital project which uses specificially identified savings, or specifically projected revenue increases.This should determine the accuracy of the prognosticators and raise a question about their future prognostications, either good or bad.
Within corporations there are those who have perfected the art of "justifiying" their projects so that they get a larger share of capital projects approved. And they mave have been transferred and not on the scene by the time poat audits reveal the shortcomings of the justification projections. But if they are usually very close to being "right on" they should be recognized and appropriately rewarded.
When one looks at the "overall returns" as are illustrated with the preceeding posts the individual projects become lost. Sometimes the "wrong person" becomes too powerful and then the big picture begins to change.
The whole "cost of capital" is really an interesting subject which is a subject that is not one of expertise for me...but just enough to get me into trouble. Thus, any financial engineers or investment engineers out there, please take this over for me.
Return on investment (ROI) is:
net margin * asset turnover * financial leverage
Net margin is the net profit ratio based on revenue...sell $100 of stuff and net out $25 and your net margin is 25/100 or 25%. For CNI last year they had revenue of $8.3B and net of $2.1B....pretty darned impressive.
Asset turnover is the sales/assets. For CNI they use $25 Billion of assets to produce those $8.3 billion of sales. Railroads, as we know are very asset intensive. To realize how capital intensive, one should compare to other industries. Thus, their asset turnover is .33.
Financial leverage is assets/shareholder equity. CNI has shareholder equity of $11.2B for finacial leverage of 25/11.2 or 2.2x.
For CNI these numbers are - margin 25.36, asset turnover of .33, and financial leverage of 2.23
ROI = 25.36 x .33 x 2.23 or 18.7%
Or another way is net margin/shareholder equity. The neat thing about adding the asset turnover is that you see how critical assets are to a company. Think that is not important...check out the assets of CNI vs Microsoft. Or Coca Cola to Exxon Mobil.
So, by plugging in the investment required and the hurdle rate, you can see why companies have such a high platform for making an investment choice.
Paul, you should be looking for companies with returns well past 10%. Most good companies have ROI of 10-15%. Most really good companies are in teh 15-20% range. Great companies are well above 20%. Microsoft ROI is 44.34 and Coke is 42.3. AAPL is 37%.
Do not mix up the ROI (company return on investment) to your return on investment in a company. Your return on investment is based very heavily on the mindset of Mr. Market at any given time. In other words, what the market will pay for a company is not necessarily what the return will be.
If a railroad, or any other given company would invest in low hurdle rate projects, they would become even more asset bloated and returns would be even less. Put it another way and if all these projects were funded, the $$$ would have to either come from shareholders or debt. Most railroads like a LT Debt ratio of about 40%. I asked the CNI CFO why not use the free cash flow to pay off all debt and he replied that debt is a cheap source of capital these days. Much more cheaper than equity cost of capital, which is the expected returns from investors....and I wont even begin to address that.
Capital structure, expenditures, and financing are very interesting (but somewhat dry) aspects of railroading. It is easy to say...why not put a power switch into that siding. Well, figure a couple of million for the planning, purchases, and execution and it is much cheaper to have a train crew throw a switch...until the volumes and costs savings justify that power switch.
Paul, all of my sources of data are from the Morningstar.com website. Go take a look at the financials for railroads and other companies.
Ed
Thanks for that confirmation and additional "data points". What is the "base" for each of those "return" figures ? Book value of stockholder's equity ? Market capitalization ? Net asset value ? Something else ?
But I would - because even if they returned that $$$ to me either way, none of the investment opportunities available to me would yield anywhere near 10%. When the RR has exhausted those, they can then pay me whatever they've earned - and then maybe we'll take about dividends or repurchased shares . . .
- Paul North.
My railroad, CNI (Canadian National) has a 12 month return on investment of 18.7% and return on invested capital of 12%.
So, a hurdle rate of 20% is pretty reasonable.
I am not sure if I would want the company to in vest in 10% deals when they could be returning that $$$ to me either in the form of dividend payments or repurchased shares.
With respect - I too am under the impression that the 'hurdle' for capital projects that are "internally" financed by the railroad's own internally-generated cash flow from operations - and perhaps for those financed from outside sources as well - is in the range of 20%, and was going to post to that effect as well. The rationale is that there are so many worthy projects - aside from those already mandated by law, regulation, contract, etc. - competing for the limited remaining capital available that in accordance with the theory, the Internal Rate of Return is calculated for each, and those with the highest IRR's get the priority for funding, starting from the top down. As a matter of administrative practice and result, the informal rule of thumb is not to bother doing an extensive work-up and submitting a project if the IRR is much below 20%, because there will usually be enough other projects with higher IRR's that will get funded and thereby use up all of the available capital funds.
I'm pretty sure we had a well-informed discussion of this within the last year or two, or another thread here. If I recall correctly, someone - pehaps dining car also ? - made the point that proposed projects which are funded and implemented ought to be audited after a year or two to make sure that the actual returns/ profits lived up to the expectations and promises of their sponsors.
More broadly, as a matter of policy and shareholder relations, the company may have decided that if the IRR for proposed projects is less than 20%, then it is better for the RR to keep the money as cash and do something else with it instead that supposedly has better IRR prospects - such as acquire another company - or other perhaps intangible benefits such as doing more to enhance shareholder value, such as either keep it as "retained earnings", pay it out as dividends, or pay it out via a "stock buy-back" program, pay off corporate 'raiders' such as The Children's Fund (which CSX was confronted with), etc.
But personally, I view those policies as short-sighted and result in passing up a lot of good opportunities. In a world now where the interest and earnings rates are so low for alternative investments - I think only "junk bonds" are much over 6% - any investment that is likely to earn between 6% and that 20% hurdle ought to be pursued, even if it means borrowing more money, all the way right up to a RR's practical "credit limit" (or maximum debt/ equity ratio covenants, etc.).
For example, last year, NS sold $250 Million of 100-year bonds, at a face amount or nominal interest rate of 6.00 %, and an actual rate of about 5.95% if I recall correctly. If someone proposes a project that will yield only 10%, I wouldn't turn it down because it's not up to 20 % - that would be "leaving potential money on the table". Instead, I'd say go borrow some more of that money at 6%, do the project, and then get the 4 % difference - which even after the capital recovery, mind you - for the company and eventually for the benefit of the shareholders, one way or the other. To turn down projects with IRR's in that range between 6 % and 20 % is to deny shareholders the opportunity to make that money, which is a disservice to them - for no good reason that I can discern, only because of an arbitrary rule of thumb. But that's just me . . .
Or maybe not. Sure, "in a perfect world" Buffett & Co. would like to get 20 % returns all the time, but as has been noted in many places many times, they can't - there are just not that many prudent opportunities for them to fully utilize their $38 Billion of cash as noted above and obtain a high rate of return. You know that the rates of return for most 'safe' investments are in the 1 % (CD's) to 5 % range (30 year mortgages), and BH is facing the same array of unattractive choices for putting their funds to work - the recent gains in the various stock markets are not likely to be repeated. Compared to those alternatives, 6.0 to 7.2 % from BNSF - together with the good possibility for higher profits as the economy improves and the railroad gets more traffic from other macro-economic trends - looks like a smart investment. While that return is surely not 20 %, it's a whole lot better than 0 or 1 or 5 % - so the smart move was for BH to buy BNSF.
Same logic should apply to a railroad's evaluation of capital project investment opportunities, it seems to me . . . Even if it doesn't have an IRR of 20 %, right now I'd take all the 10 and 15 % projects I can get . . . wouldn't you ? If not, then why not ? What are you waiting for ?
Anybody have something additional, contrary, or different to add to the above ?
P.S. - At least 2 glaring and significant factual errors in that Railway Age squib linked above: In my world, $1 billion + $1.5 billion = $2.5 billion, not $2.25 billion as stated in the 3rd line of the 1st paragraph. And in the very last line, the Class A share prices on last Wednesday, MArch 09, 2011 were not $341 - the closing price was more like $129,074 per share (yes, that's right - One Hundred Twenty-Nine Thousand, Seventy-Four Dollars US for each share - it's a long story, unique to B-H . . . ). - PDN.
[quote user="billio"]
Paul_D_North_Jr: blue streak 1: Found an article that BNSF paid Berkshire Hathaway a $1B dividend this year and $1.5B to BH after the buyout in 2010. Appears that this will be more than enough to pay for the carrying costs of the amount BH had to allocate for the purchase? Based on the $22 Billion that BH used to buy the rest of BNSF that it didn't already own (per the lInked Railway Age article) - those are annual returns of 4.54 % and 6.82 %, respectively - considerably better than what's available in money market funds, CDs, most bonds, and most stock investments. For comparison, to recover a borrowed amount over 30 years at 6.00 % interest requires an annual 'payback' of about 7.2 %, so they're not too far off that as a 'benchmark'. Without a doubt it was a good buy - the RA article provides some more details. - Paul North.
blue streak 1: Found an article that BNSF paid Berkshire Hathaway a $1B dividend this year and $1.5B to BH after the buyout in 2010. Appears that this will be more than enough to pay for the carrying costs of the amount BH had to allocate for the purchase?
Based on the $22 Billion that BH used to buy the rest of BNSF that it didn't already own (per the lInked Railway Age article) - those are annual returns of 4.54 % and 6.82 %, respectively - considerably better than what's available in money market funds, CDs, most bonds, and most stock investments. For comparison, to recover a borrowed amount over 30 years at 6.00 % interest requires an annual 'payback' of about 7.2 %, so they're not too far off that as a 'benchmark'.
Without a doubt it was a good buy - the RA article provides some more details.
A 20 percent return on a capital intensive enterprise like railroads seems unrealistic. I suspect you are remembering (??) such a number in another context.
In other ages - such as the 1960's - 1970's, with different participants and reputations, and with the railroad in less great condition (physical and economic) than it is now, this would have been called "looting the railroad subsidiary to enrich the parent conglomerate corporation". Many railroad "holding companies" back then were accused of that, not the least being Penn Central . . . .
Without some objective reference as to the condition of the railroad and the amounts involved, it could be hard to tell the difference. In my view, an honest and profitable relationship would be a "2-way street" of money flows - into the railroad when it needs it for sensible investment that can yield a profit, and then a return on that investment back to the parent, together with the profits of the investment and other operations, etc. This appear to be of the latter kind.
Here is an article on Buffett's planned acquisition of Lubrizol Corp for $9 Billion announced this morning. http://www.npr.org/templates/story/story.php?storyId=134527518
"We have met the enemy and he is us." Pogo Possum "We have met the anemone... and he is Russ." Bucky Katt "Prediction is very difficult, especially if it's about the future." Niels Bohr, Nobel laureate in physics
Paul_D_North_Jr blue streak 1: Found an article that BNSF paid Berkshire Hathaway a $1B dividend this year and $1.5B to BH after the buyout in 2010. Appears that this will be more than enough to pay for the carrying costs of the amount BH had to allocate for the purchase? Based on the $22 Billion that BH used to buy the rest of BNSF that it didn't already own (per the lInked Railway Age article) - those are annual returns of 4.54 % and 6.82 %, respectively - considerably better than what's available in money market funds, CDs, most bonds, and most stock investments. For comparison, to recover a borrowed amount over 30 years at 6.00 % interest requires an annual 'payback' of about 7.2 %, so they're not too far off that as a 'benchmark'. Without a doubt it was a good buy - the RA article provides some more details. - Paul North.
blue streak 1 Found an article that BNSF paid Berkshire Hathaway a $1B dividend this year and $1.5B to BH after the buyout in 2010. Appears that this will be more than enough to pay for the carrying costs of the amount BH had to allocate for the purchase?
BNSF's financial statements are consolidated into the Berkshire statements, so intercompany dividends have no effect on consolidated reported earnings. In addition, BH has a long term problem in finding sufficiently profitable enterprises in which to invest. Under those circumstances, it is entirely possible that they might decide retention of the cash in BNSF to fund additional capital projects is the best available investment.
MP173 Not following your question. I am not sure how BNSF/BH accounting is handled (if earnings are in the form of a dividend, etc). Where did you read the article?Ed
Not following your question.
I am not sure how BNSF/BH accounting is handled (if earnings are in the form of a dividend, etc). Where did you read the article?Ed
Try railway age:
http://www.railwayage.com/breaking-news/berkshires-billion-dollar-bnsf-dividend.html
My question is does this mean that BH made a very good buy?
Found an article that BNSF paid Berkshire Hathaway a $1B dividend this year and $1.5B to BH after the buyout in 2010. Appears that this will be more than enough to pay for the carrying costs of the amount BH had to allocate for the purchase?
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