Trade-off between ROIC & Growth to create Shareholders Value

Trade-off between Growth & ROIC to create shareholders value Growth ROIC

How does organization creates shareholders value?

Two ways to create shareholders value…

First through future growth of business &

Second, higher Return on Invested Capital (ROIC)

Both will lead to higher Price/Earning multiple

How does a company achieves identical P/E during high growth & maturity life-cycle?

* Assuming 10% cost of equity, no debt, and 10 year’s excessive growth followed by 5% growth at historic levels of returns on invested capital 17 5% 35% Return / Maturity Phase 17 13% 14% Growth Phase Implied P/E Expected Growth Expected ROIC

Growth Phase ** Reinvestment @ 93% To achieve P/E of 17 during high growth phase organization achieves ROIC of 14% which is modestly higher than Cost of Capital of 10% however 93% of earnings were reinvested to achieve sustainable growth of 13%. This leads to only small amount of earnings growth converted to Free Cash Flow 8 7 Free Cash Flow 105 93 Reinvestment 113 100 Operating Profit less taxes Year 2 Year 1

Return/Maturity Phase *** Reinvestment @ 14% During the maturity phase when growth rates become moderate/low organization achieves ROIC of 35% and reinvest only 14% of earnings to sustain growth of 5%. In this case shareholders value is created by generating huge cash flow 90 86 Free Cash Flow 15 14 Reinvestment 105 100 Operating Profit less taxes Year 2 Year 1

Growth & Return phase takes very different route to generate same multiple P/E. Top executives should pursue different growth & investment strategies to increase cash business P/E

The most important question top executive faces how much of a company’s current value can be attributed to expected Growth or Return on Capital (ROIC)

In a normal 2-part model that most executive follows, first they estimate the value of current earnings in perpetuity, assuming no growth. The model then attributes the remaining value to growth. However this approach misleads because it doesn’t take into account Return on Capital (ROIC). It can be seen with an example of consumer goods manufacturer and Discount retailer

Discount retailers fight it out primarily on price, which translates into lower margins and relatively low returns on capital—similar to Growth, Inc. In contrast, consumer goods companies compete in an environment where brand equity can generate higher margins and returns on capital, making them more like Returns, Inc. The discount retailer is actually expected to grow faster and to create more value from growth than the consumer goods company, whose high valuation would be primarily based on high Return on Capital

By relying on 2-part model CEO of the consumer goods company might increase investment or discount prices to drive growth, potentially destroying shareholder value in the long run. By digging a little deeper and appreciating the role of return on capital, the CEO would more likely focus on protecting high returns and market share

In order to come out of this dilemma top executive should follow 3-part approach of value creation Current Performance Return Premium Value from Growth

Current Performance Current performance should be estimated in the usual manner, as the value of current after-tax operating earnings in perpetuity, assuming no growth. Intuitively, this is the value of simply maintaining the investments the company has already made

Return Premium This is the value a company delivers by earning superior returns on its growth capital. In order to assess how a company’s return on growth capital influences its P/E multiple, discounting a company’s cash flows as if they grew in perpetuity at some normalized rate, such as nominal GDP growth. The result is a good proxy for the premium a company enjoys in the capital markets because of its high returns on future growth capital

Value from Growth This value represents how much a company delivers by growing over and above nominal GDP growth. It can be calculated as that portion of the company’s current market value that is not captured in current performance or the return premium

Consumer goods company enjoys high risk premium consistent with its high historical returns on capital Discount retail enjoys value from growth

An executive might change his or her insights about the consumer goods company and the discount retailer by using this 3-part model

In the consumer goods sector, preserving the return premium must be paramount, but anything the company can do to increase its organic growth rate while preserving its return premium would translate directly into shareholder value and the possibility of a very high multiple In contrast, the CEO of the discount retailer would face a tiny premium for return on capital, since his or her company derives most of its value from the rapid growth prospects. Anything this company could do to increase its ROIC, possibly even reining in its growth rate, would add value

By applying the model to calibrate the trade-off between growth and return, it can be determine that a top management priority is to redirect some attention from growth to operations improvement

Thank You Please provide your feedback. Your feedback will be highly appreciated For more information please contact: Deepak Agrawal [email_address] http://www.deepakagrawalblog.wordpress.com/ http://in.linkedin.com/in/deepakagrawal2009

Trade-off between ROIC & Growth to create Shareholders Value

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