Some brainstorming on required rate of return

We often hear investors say that they are seeking a 15% return and almost as often we hear managers says that their objective is to achieve at least this level of return, so much so that this figure has become almost mythical. What's going on here?
In current market conditions, the required rate of return from a stock with average risk is about 9%, i.e. the 10-year yield on government bonds (about 4.1%) plus a risk premium of about 4.5%. So 15% is really too much to ask, isn't it? Not for companies with a beta coefficient of at least 2.4. But fewer than 0.2% of major listed European companies have such a beta!

How can a company achieve and sustain this 15% level?

• Through leverage the company takes on debt and can raise its ROE above its ROCE as long as ROCE is higher than the net cost of debt. The greater the leverage, the more it is able to do so. For a medium-risk company, achieving ROE of 15% probably requires gearing (debt/equity) of about 150%. This is comparable to France Télécom's current gearing, but few companies have such recurrent cash flow. More fundamentally, using leverage to achieve this 15% return is tantamount to raising the risk considerably for investors and for the company. This is clearly the case in an LBO, but in an LBO everyone is aware of the risk.
  Is this what the investor who requires 15% really wants?
   
• Through creative accounting, e.g. pooling of interests (whose days are numbered in Europe), and massive asset write-downs that have the same impact and which groups like AOL Time Warner, Alcatel and others are currently doing on a massive scale, makes entire whacks of equity disappear, thus making it easier to achieve 15% ROE. But this is obviously a trap. Just because some of the shareholders' funds on the balance sheet have (perfectly legally) disappeared does not mean that that shareholders are not justified in requiring a certain return on this equity!
  But is this what the investor who requires 15% really wants?
   
• Through deconsolidation: the company puts its least profitable assets in non-consolidated companies, thus increasing its apparent return. However, this is a subterfuge and could mislead investors and, unfortunately, occurs more frequently than generally thought. Just have a look at Coca-Cola. Its after-tax ROCE looks great (18% in 2000) and its debt, moderate (0.84 times EBITDA), until you consider that its assets (Coca-Cola Bottlers), which have a book value five times greater ($41bn) than their value on the consolidated balance sheet ($8bn), have been skilfully grouped with the $25bn in debt that finances those assets in 40%-held subsidiaries. Obviously, they are consolidated only as an associate undertaking, and neither the debt nor the assets appear on Coca Cola's balance sheet. The ROCE of these assets, which are not on Coca-Cola's balance sheet, is 2%, and their EBITDA is only $5.2bn (compared to $25bn in debt…). It would be unthinkable for Coca-Cola to let its subsidiaries go bust, as they carry its name and are a part of its business. If we reconsolidate them, we see that the group's true after-tax ROCE is 6.2%, not 18%, and its debt amounts to 3.3 times EBITDA, and not 0.84 times.
  Is that what the investor who requires 15% really wants?
   
• Through an increase in operating risk: to simplify, the company could expand in Russia or Argentina, say, where standard ROCE is much higher than in Europe because of the greater risk.
  But is this what the investor who requires 15% really wants?

In fact, economic theory and common sense tell us that, over a given period, ROCE corresponds to the return that is required under normal conditions, given the level of risk. And this is increasingly the case with deregulation and technical advances, which are doing away with barriers to entry faster and faster. Major groups who are leaders in their fields with patents, well known brand names, strong market share and powerful distribution tools on mature sectors only manage to make back their cost of capital or slightly more. These include ENI, Bayer, Air Liquide and… Coca-Cola.

A company creates value when it invests in projects that, at average risk, return, nowadays, 7 to 9%, and not 15% and above. To demand 15% is to miss out on lots of value-creating investments!
For an investor to demand 15% at an average risk level would be just as unreasonable as to demand an immediate 50% jump in the minimum wage or a 33% cut in the working week at the same salary. Even Karl Marx wouldn't be that unreasonable!
At an average level of risk, a 15% return is unsustainable and is unjustifiable from a theoretical point of view and therefore is no more justified than the Coué method. Obstinately demanding 15% can push managers into dangerous behaviour, such as excess debt and aggressive deconsolidation. Let's hope that the managers who set this 15% target do so on equity that has been subject to one-off write-downs or goodwill, in fact achieving just 9% on total shareholders' equity. If they do so, then we can forgive them!