HOLT

November 2012

HOLT NOTES

bryant.matthews@credit-suisse.com
312.345.6187
raymond.stokes@credit-suisse.com 44.20.7883.6143

Cash Flow Return on Equity (CFROE)

Definition
Cash Flow Return on Equity (CFROE) is an
internal rate of return (IRR) particularly suited
to businesses that operate on a spread basis,
such as Banks that earn income at a prevailing
lending rate while paying depositors the
prevailing cost of funds. CFROE is
approximately equal to Cash Earnings as a
percent of Tangible Equity.
Industries using CFROE

Banks

Diversified Financials

Insurance

Mortgage REITs

Example
HSBC Holdings is a Diversified Bank. Using the
CFROI model, a very low return pattern is
exhibited over time with HSBCs operating return
consistently below 1.6%. This is well below the
cost of capital and the average CFROI of 6.0%
earned by Industrial/Service firms! Under the
CFROI model, the banks assets (loans) are not
netted off against its liabilities (deposits) and
since these are very large numbers we obtain a
low and unhelpful picture of performance.
HSBC Holdings
CFROE %

CFROE %

CFROI %

CFROI %

DR %
20
15
10
5

1995

2000

2005

2010

DR %
20

HOLT Treatment
HOLT calculates Cash Earnings and Tangible
Equity for all CFROE companies with some
additional adjustments for Banks and
Insurance firms.
Base Cash Earnings are as follows:
Net Income before Preferred
+
Preferred Dividend & Minority Interest
+/- Special Items (after tax)
Monetary Holding Loss
+
Stock Option Expense
+
Amortization of intangibles
+
Pension Adjustment

Travelers Companies

15
10
5
0
1990

1995

2000

2005

2010

HOLTs CFROE model measures the returns

earned by equity investors only. This model is
better suited for measuring the returns earned by
Financial institutions that rely on spread-based
profit making. Deposits are netted against loans,
resulting in superior insight into the spread
earned by the firm over its obligations. Using
CFROE, HSBC is a strongly positive spread
business from 1991 to 2007.

Coverage
Approximately 1800 companies are assigned
to the CFROE framework. Of these, 55% are
Banks, 14% Insurance, 4% Real Estate and
27% Diversified Financials such as American
Express, Goldman Sachs, Capital One
Financial Corp and Credit Suisse.

Glossary of Terms
Generic adjustments

Cash Earnings:
Net income
+ Preferred Dividends / Minority Interests
Total cash flow generated on all Invested
Tangible Equity consists of:
Capital including Minority Interests and
Shareholders Equity
Preference capital (see tangible equity
+
Preferred Stock and Minority
adjustments)
Goodwill
- Special Items
Pension Assets
after-tax non-recurring items
Insurance Additional adjustments
Unrealized Gains/Losses
- Monetary Holding Loss
Cash Earnings: The Present Value (PV) HOLT estimate of purchasing power loss of
adjustment for losses is added back while the equity due to inflation (calculated as beginning
Other
All CFROE firms have a Non-Depreciating cost of Float to Reserves is deducted.
of year tangible equity multiplied by change in
Asset release at the end of the project equal to
GDP deflator)
the initial Tangible Equity. All CFROE Adjustment is also made for prior year losses and + Stock Option expense
Income Statement charge added back to
companies fade to a return level of 7.5% realized gains losses.
Gross Cash Flow and deducted from valuation
compared to 6.0% for Industrial/Service firms
Example
using the CFROI model.
as a Debt Equivalent. Firms are accountable
Travelers Companies Inc. is a Property and for any potential claim on stock option plans as
Casualty Insurance provider. Under the CFROI a debt equivalent calculated as (no. of option
See Glossary of Terms for a more details
framework, the cyclical returns of this sector are exercisable) x (Weighted average price regarding the above adjustments.
not as evident. Moreover, the operating return closing price).
profile is consistently below the discount rate.
+ Amortization of Intangibles
Banks Additional adjustments
Non-cash item added back to Gross Cash
Cash Earnings: Loan loss provisions are added
back and net loan losses are deducted, both Using the CFROE model, Travelers reveals a Flow. Recent IFRS change makes this less an
after tax. This puts gains/losses on loans back clear cyclical pattern in its operating return. In issue. IFRS rule change stopped amortization
addition, CFROE are only below this discount of Intangibles, but is relevant when comparing
onto a cash basis.
CFROE pre and post IFRS.
Tangible Equity: After Tax Loan Loss Reserves rate during cyclical troughs.
are added back.

 Cost of Float for reserves - In our example

above, as we move through time we will need to
reverse the $9 credit steadily over the next 3
years. The Insurance Company would have to
apply a "write-up" to the reserve balance each
Tangible Equity:
year to ensure that there was $100 at the end of
Common equity
3 years to pay the claim i.e. we need to write-up
+ Preferred Stock and Minority Interest by $3 each year over next 3 years. This is
CFROE measures the return on total equity effectively a charge which needs to be deducted
capital employed including Preference capital to calculate cash flow. We calculate this based
and Minority Interest capital.
on the total discounted reserve balance and
Goodwill
estimate the "write-up" based on the reserve life
CFROE excludes goodwill
and the real debt rate.
+ Pension Liability
HOLT removes the impact of pension Losses related to prior years - Within the
accounting as recorded in the Balance Sheet annual claims expense there is an element that
(removes the defined benefit obligation from relates to prior year policies i.e. additional
liabilities) and treats the liability as a debt reserving charge or excess reserve release. We
equivalent in the valuation.
want to remove any distortion that may be
Unrealized Gain
caused by potential over/under reserving and
Gains on AFS (Available for Sale) reserves are hence remove any losses related to prior years
taken through equity. These can be material when we compute the gross cash flow.
in size and can distort reported book equity.
We remove the gain in calculating the tangible Realized Gains/Losses - We strip out any
equity and subsequently include the gain in gains/losses that occur on the timing of
valuation,
through
Market
Value
of securities sales, since we want the CFROE to
Investments.
measure the profitability of the underwriting
business and not to be artificially boosted by any
Banks Additional adjustments
one-off gains or losses from security sales. Also,
note that the economic gain on the investment
Cash Earnings:
occurs with changes in market value and not
Loan loss Provisions are added back to Cash when the assets are sold.
Earnings and actual losses sustained are
deducted. This gives a clearer picture of the Tangible Equity:
true underlying economics of the bank.
PV Adjustment for Reserves - Given the
Tangible Equity:
adjustment we are making to the cash flow for
the PV Adjustment for Losses, we need to
The Loan loss Reserve is added back, after restate the total claims reserve by the difference
tax. This really forms part of the equity on between the PV of reserves and the Fair value
which we want to measure the true return to (book value) of the reserves. We add the
shareholders.
difference between the PV and fair value to
compute the tangible equity. As with the cash
Insurance Additional adjustments
flow adjustment, we estimate the reserve life
(These relate only to the non-life elements of based on the reserving triangle data, and
the business and are especially relevant for discount the expense using a real debt rate.
multi-line firms).
+ Pension adjustment
Defined Pension Plan related Income
statement charge is added back to Gross Cash
Flow. Service cost is deducted.

HOLT Whitepaper(s)
Bass, Kevin, CFROE HOLTs Financial
Services Model. HOLT publication, October
2005.
Hillman, Thomas and Pablo Cossaro HOLTs
Improved Estimation of REIT Valuations, HOLT
Wealth Creation Principles, April 2011.

Cash Earnings:
PV Adjustment for Losses - Financial
accounting requires that claims be reserved for
on a nominal basis although the payout of
claims typically takes about 3 years. For
example you need to reserve $100 today to
pay a claim of $100 in 3 years. The PV of this
$100 is estimated at lets say $91. In this
case we would add back the accounting
defined charge of $100 to gross cash flow and
subtract the $91, so we get a net benefit of
$9 to gross cash flow. This approach actually
reflects the true economics of the insurance
business.

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November 2012

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