CTAS - Cintas: Economic Profit Is Underappreciated Not As Pricey As It Appears

2024-06-13 13:06:49 ET

Summary

• Economic profit is a measure of how much value a company is able to generate.  It is the difference between ROIC and the cost of capital.
• Cintas can raise capital at a cost of 9.53% and deploy that capital in the business and earn 35.71%. For every dollar you give Cintas, they turn it into three.
• Using an unbiased measure of the opportunity cost of the investment, Cintas offers a total return of more than double the opportunity cost.

Introduction

One limitation of the accounting profit that is presented in an income statement is that it does not reflect the opportunity cost of the profit. For debt, the income statement reflects interest expense, which is the cost of securing debt financing for the business. There is no such item on the income statement to reflect equity financing. Instead, it is assumed that whatever is left over after paying expenses is sufficient to compensate equity investors for providing capital to the business.

In this article, we recalibrate our view and instead look at economic profit. A business, in essence, is there to create value. A publicly traded business taps debt and equity markets for capital and then deploys that capital to create value over the cost of the capital obtained. Economic profit is simply the return on capital for business compared to the cost of securing capital through the debt and equity markets. If a company can secure financing at 10% and use the financing for activities that earn a 15% return, then the economic profit for the business is 5%. This 5% is not reflected in an income statement. Furthermore, it is possible for a company to secure financing at 10% and use the capital for projects that earn 8%. In this case, there is an economic loss of 2%, but it could still show a profit in the income statement because the 8% return has a value above 0%....

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