Chapter 5 on Valuation and Reporting in Organization
- 1. Chapter 5: Thinking about Return on Invested Capital & Growth
- 2. Table of Content 1.ROIC as a fundamental Driver of Value 2.Framework for Value Creation 3.An Empirical Analysis of ROIC 4. ROIC by Industry, Size & Growth 5. Decay Analysis 6. Closing Thoughts
- 3. 1.ROIC as a fundamental Driver of Value A company can be analyzed in various ways, by using Revenue, Net Income and Asset Growth but all of these cannot be used individually hence the Net Income must be precisely matched with Invested Capital. ROIC is the most used company measure and not only allows companies to compare their success with invested capital but also assess its return relative to capital investment risk It also compares returns on invested capital to return on alternative investments.
- 4. 1.1 An Insight into calculating ROIC
- 5. 1.1 ROIC and Growth By focusing on ROIC and growth, forecasts can be placed in proper context. While forecasting a valuation model, projections must fit with the capabilities of the company and the competitive dynamics of the industry. As seen from Figure 1 below, it is assumed that cost of capital for a hypothetical firm equals 10% and current revenues equal $1 Billion, otherwise making no other projections. Using the Enterprise DCF method and values solely from Fig 1, the company is valued and projection are as shown in Figure 2 Figure 1: The fundamental Drivers of Value
- 6. 1.1 ROIC and Growth Figure 2: Valuation Based on Fundamentals
- 7. Home Depot and Lowe’s Return on Invested Capital Analyze Historical Performance • Before projecting future cash flow, examine the company’s historical performance. A good analysis focuses on the key drivers of value: return on invested capital (ROIC) and growth. ROIC measures a company’s ability to create value. • Both Home Depot and Lowe’s have struggled to maintain ROIC in recent years. Home Depot no longer enjoys a performance advantage over Lowe’s. How do we compute ROIC? percent 1 ROIC measured with goodwill and acquired intangibles. Goodwill and acquired intangibles do not meaningfully affect ROIC for either company. 0 5 10 15 20 2000 2001 2002 2003 2004 2005 2006 2007 2008 Home Depot Lowe's 1.2 Analyze Historical Performance: Analyzing ROIC 7
- 8. 2.0 Framework for Value Creation – Relevance of ROIC • The formula above is a simple yet powerful and is known as the “Value Driver Formula”. • The underlying assumption is that cash flow growth is perpetual and formulates a direct relationship between ROIC and Growth (g). Assuming that a company’s cash flow will grow at a constant rate forever. Value creation formula for established firms
- 9. 2.1 Understanding the components of Value Creation – Peak ROIC o Expressed the traditional definition of ROIC = NOPLAT/ Invested Capital o The ratio is segmented in Tax (T), revenue and cost per unit, quantity to highlight potential sources of value creation while we value a company. o There are various questions which crop up after looking at this formula : Does the company have lower unit cost than competitors? Can the company sell more products per dollar of invested capital ? To answer the above questions and to justify high future ROIC , at least one source of competitive advantage must be identified.
- 10. 2.2 Identifying sources of competitive advantage for a firm
- 11. 2.2.1 Examples of Peak ROIC and Sustainability Source: Kaplan Financial Figure 3: General Model of Value Creation
- 12. 2.2.1 Examples of Peak ROIC and Sustainability Figure 3 reflects a general pattern for ROIC and Sustainability. It is flexible and can be used to describe different companies Reflect companies with Peak ROIC but are less sustainable and also companies who have peak ROIC near the cost of capital yet can generate excess returns over an extended period of time. Examples are “Intel” and “Johnson and Johnson”. Starting from 1973, during its initial stage Intel was a pioneer in the computer chips and store data or RAM chips industry. After creating value for a period of 10 Years, it succumbed to pressure but later regained momentum. Economic Theory dictates that firm who are able to create excess returns compared with their cost of capital invite competition.
- 13. 2.3 Recouping Initial Investments or Early Losses A few questions which crop up when a company fails to earn returns in excess of their cost of capital are : Q1 How long will it take before the company starts creating value ? Q2 How large will the initial investments (or losses) be ? Figure 4 : ROIC Projections: Value Destruction at Young Companies
- 14. 3.0 An Empirical Analysis of ROIC Source: Mckinsey
- 15. 4.0 ROIC by Industry Group Source: Mckinsey’s, Valuation (2005, p.148)
- 16. 4.1 ROIC Segmented by Size and Revenue Growth
- 17. 4.2 Empirical Analysis of ROIC We have examined a general model of value creation using economic theory and case studies. But how does ROIC and growth behave on an aggregate empirical basis?
- 18. 5.0 ROIC Decay Rates In cases where ROIC > Cost of Capital
- 19. 5.1 ROIC Transition Probability Percent, 3-year average of ROIC without goodwill 43% of companies with ROIC of <5% in 1994 still have an ROIC of <5%, 10 years later Companies with ROIC’s between 10% & 20% show little persistence, landing in any group with an equal probability 50% of companies with ROIC >20% in 1994 still have ROIC of >20%, 10 years down the line
- 20. 5.2 Empirical Analysis of Corporate Growth We have examined how ROIC behaves over time. But does corporate revenue growth has an impact ? Or does revenue growth behave as an aggregate empirical basis ?
- 21. Questions? Chapter 2. Fundamental Principles of Value Creation 21