revenuestogrowby$1billionanduseasales-to-capitalratio
of2.5,wewouldestimateareinvestmentneedforthisfirmof
$400 million ($1 billion/2.5). Lower sales-to-capital ratios
increasereinvestmentneeds(andreducecashflows)whereas
higher sales-to-capital ratios decrease reinvestment needs
(and increase cash flows).
Toestimatethesales-to-capitalratio,welookatbothafirm’s
past and thebusinessit operatesin. To measure this ratio
historically, we look atchanges in revenue each yearand
divideitbythereinvestmentmadethatyear.Wealsolookat
the average ratio of sales to book capital invested in the
business in which the firm operates.
Linking operating margins to reinvestment needs is much
moredifficulttodo,sinceafirm’scapacitytoearnoperating
incomeandsustainhighreturnscomesfromthecompetitive
advantagesthatitacquires,partlythroughinternalinvestment
andpartlythroughacquisitions.Firmsthatadoptatwo-track
strategyininvesting,whereonetrackfocusesongenerating
higher revenues and the other on building up competitive
strengths,should havehigheroperating marginsand values
than firms that concentrate only on revenue growth.
Link to Return on Capital
Oneofthedangerswefacewhenusingasales-to-capitalratio
togeneratereinvestmentneedsisthatwemightunderestimate
oroverestimateourreinvestmentneeds.Wecankeeptabson
whetherthisishappeningandcorrectitwhenitdoesbyalso
estimatingtheafter-taxreturnoncapitalonthefirmeachyear
throughtheanalysis.Toestimatethereturnoncapitalina
futureyear,weusetheestimatedafter-taxoperatingincome