1. Methodology

In this part of the article, I follow closely the exposition of the valuation formulas in the Financial Theory and Corporate Policy textbook by Copeland, Weston and Shastri. In their valuation the formulas depict the value for a firm with only equity (unlevered), but the formulas extend in a straightforward manner to the situation when firm is financed by debt and equity.

Consider, the free cash flow FCF for a firm at period t, which is given by:

FCF_t = (1 - t)\,EBIT_t + dep_t - capex_t

Denote by I = dep – capex, the new investment in period t. Growth in the firm occurs when capex is greater than depreciation consistently over time. For the remainder of this article, we shall also consider R&D expenses as part of capex. It follows that at period 1, cash inflow is given by EBIT1(1-t) and outflow is I1. In period 2, we have cash outflow I2 and cash inflow given by:

EBIT_2(1 - t) = EBIT_1(1 - t) + r_1 I_1

where r is the return to new investment from last period and so on. Since, the valuation of the firm at time 0 is given by (we consider the ex-dividend value of the firm):

V_0 = \lim_{N \to \infty} \sum_{t=1}^{N}
\frac{EBIT_t(1 - t) - I_t}{(1 + WACC)^t}

Rearranging, we obtain:

V_0 =
\frac{EBIT_1(1 - t)}{WACC}
+
\sum_{t=1}^{\infty}
\frac{I_t (r_t - WACC)}{WACC (1 + WACC)^t}

V₀ = Core Valuation + Supranormal Valuation 

At this point, we see that the first term is the book value of assets in place or Core Valuation. The second term is the discounted stream of future economic profits where economic profit = I (r – WACC). That is for a new investment to create value, it must earn a rate of return greater than the weighted average cost of capital.

To simplify things at this point, let’s assume the following:

I = K \, EBIT \, (1 - t)

where K is considered the retention rate or the investment rate. Further, let’s assume that r is constant over time. Plugging into the valuation formula above and rearranging we get:

V_0 =
\frac{EBIT_1(1 - t)}{WACC}
+
\frac{EBIT_1(1 - t)}{WACC}
*
\left[
\frac{K(r - WACC)}{(1 + rK)}
\sum_{t=1}^{\infty}
\left(
\frac{1 + rK}{1 + WACC}
\right)^t
\right]

V₀ = CV₀ + SV₀ 

Where CV is core valuation and SV is supranormal valuation.

2. Application to US Manufacturing

We consider five manufacturing firms, taken from Dr. Silva’s textbook “U.S. Corporate Profits, 1950–2024”. In his book, for manufacturing and other sectors, using sophisticated regression analysis, Dr. Silva shows that pass through from COGS and OPEX to Net Revenue is stable over time for leading firms in many sectors of the US economy. The five manufacturing firms are 3M, Avery Dennison, Goodyear, Kimberly-Clark and Owens Corning.

First, we obtain the net capex data for the years 2016 to 2024. The choice of these years is also based on the fact that US corporate tax rate changed to 21% during this period while the average state tax rate is about 6.5%. Since, state and local taxes are deductible against taxable income for federal tax purposes, we get on average a marginal tax rate of about 26% for this period. We also obtain EBIT for these years for each firm and from the two we take averages of capex and EBIT for the period and calculate K as a result.

Next, we obtain market capitalization and debt numbers together with levered beta from yahoo finance for 2024. This is combined with a yield on 10-year treasury notes of around 4% for 2024.

In the process, we obtain WACC by a weighted average of cost of debt and equity also considering the tax shield effect on debt. Once, we have computed all this, we have all the ingredients we need to calculate the core valuation and supranormal valuation of these five firms, taking as starting EBIT, that of each firm for 2024.

3. Results

We see a varied rate of return on new investment across the five firms from the figure below:

Similarly, where there is zero differential, the firm only has core valuation. From the figure below:

These results echo Dr. Silva’s findings. In page 25 of his book, he states that “even within a similar industry, profit markups vary widely, shaped by product differentiation, vertical integration, and market power.” Further, “despite economic theories predicting competitive equalization of profit rates, empirical data show that corporations like 3M maintain persistent advantages, while others like Goodyear operate under tighter constraints.”

We see the same findings here. Say, from a valuation perspective, Goodyear earns essentially a competitive return, while firms like 3M and Avery Dennison maintain a persistent advantage. Again, different firms have different rates of return on new investment starting from WACC in the case of Goodyear to 44.5% for Avery Dennison.

4. Explanation for High Rates of Return on New Investment – Real Options Theory

Investment opportunities have two main characteristics in essence – they are often irreversible (i.e. cannot be recovered) and involve a strategic timing component (wait until one learns more). In a paper by McDonald and Siegel (1986), the optimal investment strategy is not that of NPV (i.e. invest when value of investment greater or equal to investment cost). Indeed, the optimal strategy involves a threshold value for V where V = c I where c can be considerably higher than 1. In our context the net rate of return is 100*(c-1) percent and hence the high values obtained for 3M, Avery Dennison and Owens Corning can be explained via the real options theory.

References:

“Financial Theory and Corporate Policy” by Thomas E. Copeland, J. Fred Weston and Kuldeep Shastri, 4th edition, Pearson 2014.

“U.S. Corporate Profits, 1950–2024” by Ednaldo A. Silva, Springer 2025.

“The Value of Waiting to Invest” by Robert McDonald and Daniel Siegel, Quarterly Journal of Economics 1986.