Foundations of Value

OBJECTIVE:
 Explain the principles of value creation.
 Discuss the benefits of long-term value creating for companies and its stakeholders and
the economy.
 Explain the relationship between the stock market and the real economy in terms of
GDP, inflation, and interest rates.
 Explain the concept of expectations treadmill and its effect on the return to shareholders.
 Discuss the drivers of growth.

“Valuation refers to the process of determining the present worth of a

company or an asset."
- [Link]

WHY VALUE VALUE?

Value – a dimension of measurement in a market economy
- A helpful measure of performance because it takes into account the long-term
interests of all the stakeholders in a company, not just the shareholders.
Companies that maximize value for their shareholders in the long-term:
 Create more employment
 Treat their current and future employees better
 Give their customers more satisfaction
 Shoulder a great burden of corporate responsibility than more shortsighted rivals
Companies create value by investing capital they raise from investors to generate future
cash flows at rates of return exceeding the cost of capital (the rate investors require to be
paid for the use of their capital)

Conservation of value – anything that doesn’t increase cash flows doesn’t create value

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FUNDAMENTAL PRINCIPLES OF VALUE CREATION
A company’s primary task is to generate cash flows at rates of return on invested capital
greater than the cost of capital.

Growth and ROIC: Drivers of Value

Growth and ROIC

Drive Value

The amount of value that companies create is the difference between cash inflows
and the cost of the investments made, adjusted to reflect the fact that tomorrow’s cash
flows are worth less than todays because of the time value of money and the riskiness of
future cash flow.
A company’s return on invested capital and its revenue growth together determine
how revenues are converted to cash flows. That means the amount of value a company
creates is governed ultimately by its ROIC, revenue growth, and of course its ability to
sustain both over time.
While earnings and cash flows are often correlated, earnings don’t tell the whole
story of value creation, and focusing too much on earnings or earnings growth often leads
companies to stray from a value-creating path.

Relationship of Growth, ROIC, and Cash Flow

Disaggregating a company’s cash flow into revenue growth and ROIC helps illuminate the
underlying drivers of a company’s performance.
Example:
Consider two companies, Value Inc. and Volume Inc., whose projected earnings and cash
flows are displayed below. Both companies earned 100 million in year 1 and increased their
revenues and earnings at 5 percent per year, so their projected earnings are identical. If the
popular view that value depends only on earnings were true, the two companies’ values
also would be the same. But this simple example illustrates how wrong that view can be

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 Value Inc. generates higher cash flows with the same earnings because it invests only
25 percent of its profits (making its investment rate 25 percent) to achieve the same profit
growth as Volume Inc., which invests 50 percent of its profits. Value Inc.’s lower investment
rate results in 50 percent higher cash flows than Volume Inc. obtains from the same level of
profits.
We can value the two companies by discounting their future cash flows at a discount
rate that reflects what investors expect to earn from investing in the company—that is, their
cost of capital.
Value Inc. generates higher cash flows because it doesn’t have to invest as much as
Volume Inc., thanks to its higher rate of ROIC. In this case, Value Inc. invested 25 million (out
of 100 million earned) in year 1 to increase its revenues and profits by 5 million in year 2. Its
return on new capital is 20 percent (5 million of additional profits divided by 25 million of
investment).
In contrast, Volume Inc.’s return on invested capital is 10 percent (5 million in
additional profits in year 2 divided by an investment of 50 million).
Growth, ROIC, and cash flow (as represented by the investment rate) are tied together
mathematically in the following relationship:

Investment Rate = Growth ÷ Return on Invested Capital

Applying that formula to Value Inc.:

25% = 5% ÷ 20%
Applying it to Volume Inc.:
50% = 5% ÷ 10%
Balancing ROIC and Growth to Create Value

 For any level of growth, value increases with improvements in ROIC.

 When all else is equal, a higher ROIC is always good. The same can’t be said of
growth.

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  When ROIC is high, faster growth increases value, but when ROIC is lower than the
company’s cost of capital, faster growth necessarily destroys value, making the point
where ROIC equals the cost of capital the dividing line between creating and
destroying value through growth.
 Value is neither created nor destroyed, regardless of how fast the company grows.

Conservation of Value
- Anything that doesn’t increase cash flows doesn’t create value.
- Value is conserved, or unchanged, when a company changes the ownership of claims
to its cash flows but doesn’t change the total available cash flows
Example: When a company substitutes debt for equity or issues debt to repurchase
shares
- changing the appearance of the cash flows without actually changing the cash flows
doesn’t change the value of a company
Example: by changing accounting techniques

Risk and Value Creation

- A company’s future cash flows are unknown and therefore risky.
- Risk enters into valuation both through the company’s cost of capital, which is the
price of risk, and in the uncertainty surrounding future cash flows

Price of Risk
Cost of capital - the price charged by investors for bearing the risk that the company’s
future cash flows may differ from what they anticipate when they make the investment.
- Equals the minimum return that investors expect to earn from investing in the
company.
- Also called the discount rate, because you discount future cash flows at this rate
when calculating the present value of an investment, to reflect what you will have to
pay investors.

The terms expected return to

investors and cost of capital are
essentially the same.

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The Math of Value Creation

 Net operating profit less adjusted taxes (NOPLAT) - represents the profits generated
from the company’s core operations after subtracting the income taxes related to
the core operations.
 Invested capital - represents the cumulative amount the business has invested in its
core operations—primarily property, plant, and equipment and working capital.
 Net investment - is the increase in invested capital from one year to the next:
Net Investment = Invested Capitalt+1 − Invested Capitalt

 Free cash flow (FCF) - is the cash flow generated by the core operations of the
business after deducting investments in new capital:
FCF = NOPLAT − Net Investment

 Return on invested capital (ROIC) - is the return the company earns on each dollar
invested in the business:
NOPLAT
ROIC =
Invested Capital
 Investment rate (IR) - is the portion of NOPLAT invested back into the business:
Net Investment
IR =
NOPLAT
 Weighted average cost of capital (WACC) - is the rate of return that investors expect
to earn from investing in the company and therefore the appropriate discount rate
for the free cash flow
 Growth (g) - is the rate at which the company’s NOPLAT and cash flow grow each
year.

THE EXPECTATIONS TREADMILL

The performance of a company and that of its management are frequently measured
by total returns to shareholders (TRS).
If managers focus on improving TRS to win performance bonuses, then their
interests and the interests of their shareholders should be aligned. This is true for periods of
at least 10 years. However, TRS measured over periods shorter than 10 years may not
reflect the actual performance of a company and its management for two main reasons:
1. Improving TRS is much harder for managers leading an already successful company
than for those leading a company with substantial room for improvement.
A company’s progress toward performance leadership in any market will attract
investors expecting more of the same, pushing up the share price. Managers then
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 have to pull off herculean feats of real performance improvement to satisfy those
expectations and continue improving TRS. We call their predicament the
“expectations treadmill.”
2. When TRS is analyzed in the traditional way, it doesn’t show the extent to which
improvements in operating performance contributed to the measure as a whole.
Improved operations constitute the only part of the measure that creates long-term
value and is also within management control.

RETURN ON INVESTED CAPITAL (ROIC)

The value of a business depends on its return on invested capital (ROIC) and growth.
The higher a company can raise its ROIC and the longer it can sustain a rate of ROIC greater
than its cost of capital, the more value it will create.
Being able to understand and predict what drives and sustains ROIC is critical to every
strategic and investment decision.

Drivers of Return on Invested Capital

To understand how strategy, competitive advantage, and return on invested capital
are linked, consider the following representation of ROIC:

This version of ROIC has a similar meaning to the traditional definition, NOPLAT divided by
invested capital. However, to highlight the potential sources of competitive advantage, the
ratio was disaggregated into post tax revenue minus cost divided by invested capital per
unit
If a company has a competitive advantage, it earns a higher ROIC, because it either charges
a price premium or produces its products more efficiently (at lower cost or lower capital per
unit), or both.

The Structure-Conduct-Performance (SCP) Framework

- The strategy model that underlies the thinking about what drives competitive
advantage and ROIC.

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 - According to this framework, the structure of an industry influences the conduct of
the competitors, which in turn drives the performance of the companies in the
industry

Five Forces that Determine the Intensity of Competition in an Industry (Michael Porter)
1. Threat of new entry,
2. Pressure from substitute products,
3. Bargaining power of buyers,
4. Bargaining power of suppliers, and
5. The degree of rivalry among existing competitors.
Companies need to choose strategies that build competitive advantages to mitigate or
change the pressure of these forces and achieve superior profitability.
Because the five forces differ by industry and because companies within the same
industry can pursue different strategies, there can be significant variation in ROIC across and
within industries.

Competitive Advantage
Sources of Competitive Advantage

PRICE PREMIUM COST AND CAPITAL EFFICIENCY

 Innovative business method: Difficult-to-copy
 Innovative products: Difficult-to-copy or
business method that contrasts with established
patented products, services or technologies
industry practice
 Unique resources: Advantage resulting from
 Quality: Customers willing to pay a premium for
inherent geological characteristics or unique
a real or perceived difference in quality over and
access to raw material(s)
above competing products or services

 Economies of scale: Efficient scale or size for the

 Brand: Customers willing to pay a premium
relevant market
based on brand, even if there is no clear quality
difference
 Scalable product/process: Ability to add
 Customer lock-in: Customers unwilling or unable
customers and capacity at negligible marginal
to replace product or service they use with a
cost
competing product or service

 Rational price discipline: Lower bound on prices

established by large industry leaders through
price signaling or capacity management

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Sustainability of Return on Invested Capital
Whether a company can sustain a given level of ROIC depends on the following:

 Length of Product Life Cycle - The longer the life cycle of a company’s businesses and
products, the better its chances of sustaining its ROIC.

- a business model that locks customers into a product with a short life cycle is far less
valuable than one that locks customers in for a long time

Examples:
o While Cheerios may not seem as exciting as an innovative, new technology,
the culturally entrenched, branded cereal is likely to have a market for far
longer than any new gadget.
o Once users of Microsoft’s Windows have become well versed in the platform,
they are unlikely to switch to a new competitor. Even Linux, a low-cost
alternative to Windows, has struggled to gain market share as system
administrators and end users remain wary of learning a new way of
computing
 Persistence of Competitive Advantage
If the company cannot prevent competition from duplicating its business, high ROIC
will be short-lived, and the company’s value will diminish.
Advantages that rise from brand and quality on the price side and scalability on the
cost side tend to have more staying power than those arising from more temporary
sources of advantage, such as an innovation, which will tend to be superseded by
subsequent innovations

 Potential for Product Renewal

Most companies need to find renewal businesses and products where they can
leverage existing or build new competitive advantages. This is an area where brands
prove their value. Being good at innovating also helps companies renew products
and businesses.
Examples:
o Apple’s success with the iPod and iPhone
o Bulgari moving into fragrances
o Mars entering the ice cream business
When companies have found a strategy that creates competitive advantages, they are
often able to sustain and renew these advantages over many years.

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While competition clearly plays a major role in driving down ROIC, managers can sustain a
high rate of return by anticipating and responding to changes in the environment better
than their competitors do.

GROWTH
Growth creates value only when a company’s new customers, projects, or
acquisitions generate returns on invested capital (ROICs) greater than the cost of capital.
Finding good, high-value-creating projects becomes increasingly difficult as companies grow
larger and their industries ever more competitive.
Achieving the right balance between growth and return on invested capital is
critically important to value creation.
For companies with a high ROIC, shareholder returns are affected more by an
increase in revenues than an increase in ROIC. If such companies let their ROIC drop a bit
(though not too much) to achieve higher growth, their returns to shareholders can improve.
For companies with a low ROIC, increasing ROIC will create more value than growing
will.

Drivers of Revenue Growth

Average industry revenue growth varies considerably across industries, and there are
also big differences in growth rates among companies in the same industry. In some
industries, the most important contributors to the sector’s overall revenue growth were
price changes and mergers and acquisitions (M&A) activities.
Executives need to understand the reasons for variations in growth to assess past
growth and plan how to grow in the future. The first step is to disaggregate overall growth
into its three main components.

Three Main Components of Growth

1. Portfolio momentum: This is the organic revenue growth a company enjoys because
of overall expansion in the market segments represented in its portfolio.
2. Market share performance: This is the organic revenue growth (or reduction) a
company records by gaining or losing share in any particular market. (We define
market share as the company’s weighted average share of the segments in which it
competes.)
3. Mergers and acquisitions (M&A): This represents the inorganic growth a company
achieves when it buys or sells revenues through acquisitions or divestments.

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Growth and Value Creation
Achieving the highest revenue growth may depend on choosing the right markets
and acquisitions rather than gaining market share.
The highest growth will not necessarily create the most value, because the three
drivers of growth do not all create value in equal measure.

DIFFICULTY OF SUSTAINING GROWTH

Sustaining high growth is much more difficult than sustaining ROIC, especially for
larger companies.
Sustaining growth is difficult because most product markets have natural life cycles.
First, a product has to prove itself with early adopters. Growth then accelerates as more
people want to buy the product, until it reaches its point of maximum penetration. After
this point of maturity, and depending on the nature of the product, either sales growth falls
back to the same rate of growth as the population or the economy, or sales may start to
shrink

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