I have met many finance executives at companies with low reinvestment rates who understand and agree with our findings that high reinvestment rates are good. But they claim they don’t have many opportunities for profitable reinvestment. One CFO defended his position by stating he “never turns down positive net-present-value investments.” Upon deeper review, I found that the company’s culture and internal processes overemphasize avoiding bad investments. None but the highest-return investments are even proposed for corporate consideration. In many companies, arbitrarily tight capital expenditure budgets set a strategic tone of restraint, which in turn sets the bar very high in the mind of operating managers. Such stifling cultures need to change if finance executives want to adequately promote desirable growth investments.
Is the reinvestment rate more important for companies that earn high internal cash-on-cash operating returns but less so for those with low returns? In our research, we found that whether you have high, medium, or low returns, TSR is positively correlated with higher rates of reinvestment (see Figure 3). As we would expect, however, high-return companies get a larger benefit from reinvestment than low-return companies.
Some may question the causality in our findings that high-reinvestment companies typically achieve higher revenue growth and higher TSR. Are the successful companies the only ones who can afford to reinvest more? Do the “good” industries artificially make reinvestment appear desirable for all? We have conducted extensive research in our client studies of their individual industries, including health care, industrial, energy, technology, and other sectors, and the results are generally consistent everywhere.
Are you reinvesting enough? As our economy strengthens, CFOs should assess their companies’ reinvestment rates to ensure enough capital is being deployed to build future value via capital expenditures, R&D, and maybe even acquisitions. Within your company, examine the reinvestment rates across business units to see if enough reinvestment is occurring where the returns and opportunities are highest.
To ensure your corporate culture supports adequate reinvestment, review all business-management processes and eliminate biases against reinvestment. Consider adding the reinvestment rate to planning and performance-measurement processes. In doing so, avoid measuring and benchmarking investment as a percent of revenue, since that creates a bias in favor of less-profitable businesses.
Always measure the reinvestment rate as a percentage of “preinvestment” cash flow to assure the signals reinforce making adequate investment in the most-profitable businesses. Constantly reinforce this in planning, capital investment, and performance review meetings. Make sure everyone understands that value is not created from maximizing returns, but from balancing the pursuit of higher returns with investment in future growth.
Gregory V. Milano is the co-founder and chief executive officer of Fortuna Advisors LLC, a value-based strategic advisory firm.