Cintas: Economic Profit Is Underappreciated, Not As Pricey As It Appears (NASDAQ:CTAS)

kali9/E+ via Getty Images 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%. In our thesis, we measure the economic profit that Cintas Corporation (NASDAQ:CTAS) is able to generate. In estimating the cost of capital, we consider Cintas’ capital structure, cost of debt and cost of equity. We then consider Cintas’ return on invested capital (ROIC). We make adjustments to their income statement and balance sheet items to reflect the underlying economics and the methodology used in this article. After, we compare their dividend record and compare it with an unbiased estimate of the opportunity cost of an investment in the stock. Using these inputs and framework described, we find that Cintas is a worthwhile investment for both value and growth-oriented investors. Cintas’ Weighted Average Cost of Capital There are two forms of capital: debt and equity. Our first step in estimating the economic profit of Cintas is to first look at their cost of debt and their cost of equity. Let us look at their cost of debt. Please look at Table 1. Table 1: Issuer Rating and Cost of Debt Description Rating/Yield Outlook/Maturity Standard & Poor’s A- Stable Moody’s A3 Stable 6.15% note 5.21% August 15, 2036 Click to enlarge Source: Finra.org, Cintas 10-K for 2023, Moody’s and S&P. Cintas enjoys an A- credit rating from S&P and an A3 rating with Moody’s. Both have stable outlooks. Cintas has a fixed income instrument that matures in August 2036 that exchanged hands recently at a yield of 5.21%. This is reflective of the cost of debt financing Cintas would face should it raise debt capital today. A firm’s credit rating is focused on its credit risk. And credit risk has to do with assessing the obligor’s capacity to make promised principal and interest payments in accordance with the bond indenture. For equity, there are different methods and philosophies around calculating the cost of equity. We use the Capital Asset Pricing Model (CAPM) in which we essentially add a spread to the risk-free rate and scale the spread by the beta statistic of the particular stock. Let us review this in some detail. Please take a look at Table 2. Table 2: Cost of Equity β 1.31 Risk-free rate 4.32% Equity risk premium 4.12% Cost of equity 9.71% Click to enlarge Source: CNBC, Damodaran Online. The beta statistic is measured by regressing the returns of the stock against the market. The stock’s beta is a measure of risk that is of a different dimension than of the credit risk measured as part of the estimate of the cost of debt. If the stock moves more in relation to the market, it is considered riskier and therefore a premium will be required to compensate the investor for the increased volatility. The market as a whole has a beta statistic of 1.0 and Cintas has a beta statistic of 1.31 which means that for every step move of the market, Cintas’ stock moves more in either direction. In a sense, Cintas is penalized because the higher beta statistic means that the return investors expect will be higher. What beta statistic doesn’t tell you is that Cintas’ beta statistic is higher because it has outperformed the market. Please see Exhibit 1. Exhibit 1 (Seeking Alpha and TradingView) Notwithstanding this limitation of the beta statistic, we shall use it because it will lead to a more conservative estimate. We can consider the item an additional margin of safety if the buy thesis is sufficient. There are two other inputs to the cost of equity from Table 2: the equity risk premium and the risk-free rate. Let us now briefly look at those. The equity risk premium is simply that. It is the risk premium equity investors demand over the risk-free rate to compensate the investor for the riskiness of the investment. Depending on how and when the premium is measured, it usually oscillates between 3% and 5% for the US. Here, we use 4.12% which is the current available estimate from Damodaran at NYU. For the risk-free rate, I use the US 10-year treasury, which is a commonly used proxy for the risk-free rate. Using these inputs, we arrived at a cost of equity of 9.71%. If Cintas wanted to secure equity financing, this model states that they have to entice the investor with a 9.71% return. When a business raises capital, they usually don’t just raise debt or equity. They usually raise a blend of the two, consistent with their capital structure. Let us take a look at Cintas capital structure on Table 3. Table 3: Capital Structure Form of Capital Value($ thousands) Weight Equity Shares outstanding (diluted) 103,187 Share price $692.48 Equity market capitalization $71,454,934 96.65% Debt Long-term debt $2,474,908 3.35% Total $73,929,842 100% Click to enlarge Source: Cintas 10-Q for third quarter 2024 and Seeking Alpha. Now that we have the cost of debt, cost of equity and the capital structure, we can now estimate Cintas weighted average cost of capital. Because interest on debt is tax-deductible, we incorporate Cintas’ tax rate in our estimate. Please see Table 4 for Cintas’ weighted average cost of capital estimate. Table 4: Weighted Average Cost of Capital (OTC:WACC) Weight of debt 3.35% Weight of equity 96.65% After tax cost of debt* 4.31% Cost of equity 9.71% WACC 9.53% Click to enlarge Source: Cintas average tax rates for fiscal 2021, 2022 and 2023 is 17.2% from 10-K for fiscal year 2023 and 2022. Now that we have estimated Cintas’ cost of capital, we ask: what does this mean? How does economic profit fit in the picture? We now know that should Cintas decide to tap debt and equity markets, it will have a cost of capital of 9.53%. If it can deploy the capital in their business at rate over 9.53% then it is creating value. It is generating an economic profit. Let us now measure Cintas’ return on invested capital. Return on Invested Capital (ROIC) There are two items needed to estimate the ROIC. The numerator is the net operating profit after taxes (NOPAT). Because we want to measure the level of economic profit relative to debt and equity capital, we use a measure of cash flow that is available to both debt and equity holders. We remove taxes because it is not available to debt and equity investors. Let us look at Cintas’ recent fiscal year’s income statement. Please see Exhibit 2. We are using fiscal 2023 results. Exhibit 2 (Cintas 10-K for 2023) If we take operating income of $1,802,664 and deduct income taxes of $345,138, we arrive at NOPAT of $1,457,526. Please see Table 5. Table 5: NOPAT ($ in thousands) Operating Income 1,802,664 Income taxes 345,138 NOPAT 1,457,526 Click to enlarge The second item we need is the invested capital for the denominator. Hawawini and Viallet define invested capital as cash and cash equivalents plus net working capital plus net fixed assets. There is no one authoritative definition of invested capital, but the basic idea is to measure the capital that is actually required to the running of the business. Let us refer to their balance sheet items. Please refer to Exhibit 3 for the current assets, total assets and current liability account for Cintas for 2023. Source: Hawawini, Gabriel and Viallet Claude (2011) Finance for Executives: Managing Value Creation, 4th Edition. Mason, Ohio:South-Western Cengage Learning. Exhibit 3 (Cintas 10-K 2023) Our bias is towards making as few adjustments as possible. If the adjustment is not obvious, we prefer to leave them be. We are going to net out current assets and current liabilities. We are going to leave “property and equipment, net” as is. We also leave “investments” as is. We are going to remove “goodwill” from consideration. In an acquisition, the excess of the acquisition price over the estimated fair value of the net assets acquired is recorded as goodwill. This is more an accounting balancing item rather than reflective of the underlying economics of the business. From the non-current assets bucket, we also shall remove “operating leases, right-of-use asset” from consideration. This entry is a reflection of ASC 842 which is a recent accounting standard that requires balance sheet recognition of lease assets and liabilities. There is an offsetting account called “operating lease liability” for $138,278 thousand in the long-term liability account. Please see Table 6 for our adjusted estimate of invested capital. Table 6: Invested Capital ($ in thousands) Net Current Assets 1,708,397 Property and equipment, net 1,396,476 Investments 247,191 Service contracts, net 346,574 Other assets, net 382,991 Total Invested Capital 4,081,629 Click to enlarge In Table 7, we estimate our ROIC using the NOPAT as the numerator and the invested capital as the denominator. Table 7: ROIC ($ in thousands) NOPAT $1,457,526 Invested Capital $4,081,629 ROIC 35.71% Click to enlarge From Table 7, we can begin to see why (perhaps) Cintas trades at a high valuation. To drive home the point, let us compare Cintas’ weighted average cost of capital with its return on invested capital. Please see Table 8. Table 8: Cap Rate Minus WACC ROIC 35.71% WACC 9.53% Economic Profit 26.18% Click to enlarge Simply put: Cintas can go to the market and raise debt and equity capital at a weighted cost of 9.53% and then deploy that capital in the business and earn a return of 35.71%. This is a wonderful business. Every dollar you give the business, the business turns around and makes more than three dollars off it. Just because Cintas can earn a healthy level of economic profits doesn’t automatically qualify it as a good investment. Earning high returns on invested capital is a necessary, but not a sufficient, condition for an investment. We also have to ask, “to whom does that economic profit accrue to?” Management? Employees? Debt holders? In order to answer this question, we shall revisit our cost of equity calculation earlier in Table 2. We estimated the cost of equity using CAPM which is a statistical method of estimating the cost of equity. There are other methods to calculate the cost of equity. Also, cost of equity is the terminology used from the company’s perspective. It is the cost for Cintas to obtain equity capital. From an investor’s point of view, the cost of equity is the required rate of return. And for many investors, the required rate of return has two components: the current dividend yield and the growth rate of the dividends. Please take a look at Table 9, which presents Cintas’ total return as a combination of the current dividend yield and the growth rate of the dividends. Table 9: Total Return Dividend yield 0.79% 5-year dividend growth rate 21.37% Total return 22.16% Click to enlarge Source: Seeking Alpha In Table 10, we compare the total return with the cost of equity calculated using CAPM. The cost of equity in this case can be thought of as the opportunity cost for investing in the stock, akin to a “hurdle rate”. Table 10: Total Return Minus Cost of Equity Total return 22.16% Cost of equity 9.71% Difference 12.45% Click to enlarge One interpretation of Table 10 is that investors today are getting more in the stock than an unbiased view of the opportunity cost of the equity investment. Whereas the profile of the business using CAPM justifies a return of 9.71% return, investors are actually getting 22.16% if their five-year growth rate is an appropriate window as to how the dividends will grow in the future. Also, remember that the 9.71% cost of equity figure was arrived at using a beta statistic that penalized Cintas for outperforming the market. The beta statistic doesn’t distinguish between an upward or downward departure from the market. Risks There are risks to our thesis. One of the key risks is that we do not know how long Cintas can earn very high rates on invested capital. Typically, high ROIC attracts competitors, and this would impact Cintas’ return profile. Cintas’ margins could also deteriorate. Input costs could increase, and Cintas may be unable to pass along the increase in cost to their customers. Or their customers could internalize the uniform supply function instead of outsourcing the service, for example. Conclusion The denominator in a P/E ratio reflects accounting earnings that do not tell the entire story. The kind of earnings that Cintas earns is very high relative to the opportunity cost of those earnings. When you buy a stock of Cintas, it is like you are paying a high entry fee to gain access to a business that is going to earn high returns on invested capital. You are not going to get a high dividend yield because most of the earnings are retained and deployed at the high rates of return. Every dollar that is retained is invested and will probably bring more than three dollars. And whatever amount is paid in dividends will grow at an attractive clip. There are risks to purchasing the stock, but if you balance the risk and reward profile of Cintas, there is a logic to why its valuation seems elevated by conventional measures. Against an unbiased measure of the opportunity cost of an investment in the stock, there is a compelling case as to why the stock is a buy for both a value and growth-oriented investors.