The Drivers of Value

What is Value Creation?

What do the stock market really care about? What, really, drives value and thus price for stocks? It is actually quite simple. A company’s return on invested capital (ROIC, but sometimes called ROC) and its revenue growth together determine how revenues are converted into cash flows (and earnings). A company has to earn above its cost of capital to create value though, so therefore, it is the difference between a company’s ROIC and weighted average cost of capital, or WACC, that together with revenues that are the key drivers of value.

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The total amount of value a company can create over time is determined by a company’s ROIC-WACC spread (or above risk returns), its revenue growth, and its capacity to keep these two drivers of value sustainably high over long periods of time. The figure below is similar to the previous picture, but it brings in the time dimension, and emphasises that value cannot be generated if the ROIC is not actually above WACC. As a matter of fact, a company investing to grow when its ROIC on new investments is below its WACC actually destroys value.

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The reason why we have to think about value-creation in the way described above is that is it the only way consistent with financial theory. A company should take of projects where the net present value of those projects are positive, and they are only that when ROIC is above WACC. In corporate finance, we often talk about EVA, or economic value added, which is simply a ROIC-WACC spread (where we have made sure that ROIC is adjusted for any issues there might exist in financial reporting, like intangible assets not recognized due to accounting rules) multiplied by invested capital. Thinking of these measures, it becomes very important that we keep track of how management is incentivized within a company. Are their decision rules for taking on investments based upon solely a profitability measure in percentage terms, or are they thinking of risks and the time value of money, i.e. are they thinking of value-creation terms, which must include the cost of capital and the amount of money being invested in value-creating projects? For internal control, we should also add that return on capital employed, ROCE, might be an equally valid measure as ROIC to use when calculating EVA, if they have control over cash and other non-operative financial assets.

Since WACC is relatively stable among companies in the same sectors, and since the risk often is more difficult to change drastically for a company, I will just focus on ROIC and revenue growth in this post.

I should also add that ROIC and WACC are not applicable on financial companies, as we can’t define the income statement nor the balance sheet in the standard way. In the future, I will cover that sector to the extent I am capable (i.e. banks, insurance companies, etc.) But put shortly, the primary drivers of value are then return on equity, growth and cost of equity (the discounted cash flows are primarily dividends). In relative valuation, these aspects are related to the price to book value. 

Return on Invested Capital

There are many measurements of profitability. Return on equity (ROE), return on assets (ROA) and return on capital employed (ROCE) to mention a few. The theory behind value creation, the research done on stock market performance, and the valuation professionals in the real world agree quite unanimously suggest that ROIC – if calculated correctly – is the soundest measure of profitability. Now, it should be said that ROCE is a great measure too. It depends on what you want to know, really. It should also be said that ROCE is somethimes calculated as ROIC, which can be quite confusing. Maybe most importantly though, is understanding that we as much as possible want to separate the operative aspects from the non-operative aspects, and we can confidently state that ROIC does just that. The inputs to the calculations are the following:

  • Net Operating profit less adjusted taxes (NOPLAT) represents the profits generated from the core operations of a company, but after the income taxes that relate to those core operations has been removed. 
  • Invested Capital represent the cumulative amount the business has invested in its core operations, primarily property, plant and equipment and working capital. Invested capital is often calculated from the financing side of the balance sheet, where debt and equity are summed up, but the (non-operating) cash on the asset side are also removed.

ROIC can therefore be calculated as follows:

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Knowing that the free cash flow is what is left for the debt and equity holders after having done the investments in capital during a year, and knowing that it is impossible to grow without doing investments, some simple algebra will lead us to end up with the key value driver formula – the formula that underpins firm valuation models.

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In this equation you can see why ROIC matters so much. If you want to grow, it will cost you some part of the free cash flow today. The higher your ROIC, the “cheaper” your growth is in the sense that you still can generate high levels of cash flow today. This is obviously only a formula you can use in perpetuity when the growth rate is low (otherwise the denominator becomes so small the value goes to infinity). Yet, it gives a sense of the drivers of value, and is much more intuitive than for example the standard Gordon growth model where you simply divide the dividend next year with the cost of capital minus the growth rate. In that equation it might be difficult to see why that dividend is as high or low as it, and why the dividend can grow at the rate the equation suggests. 

 

Some short facts about ROIC

  • ROIC is primarily driven by competitive advantages that drives price premiums or cost and capital efficiencies. We will list them under “The Most important frameworks, models and equations for understanding businesses and its finances”, where we also talk about what makes ROIC sustainable.
  • The median ROIC in the U.S was around 10 percent from 1963 to 2000, but was up to 16 percent 2013. ROIC without Goodwill has increased over time, but including goodwill in invested capital will show that ROIC is quite stable, meaning companies have not been able to extract much value from their acquisitions.
  • ROIC differ by industry. Software, pharmaceuticals, IT services, tech hardware, healthcare equipment, electrical equipment, aerospace, defence and consumer staples have had high ROIC historically, whereas utilities, paper and forest, airlines, roads, telecom, oil and gas, metals and mining and household durables have delivered much worse profitability.
  • ROIC is often quite widely dispersed among companies.
  • Looking at individual companies, ROIC is often very stable over time. For example, among companies in the U.S that had ROIC above 25% in 2003, 83% delivered above 25% ROIC 10 years later in 2013.

Revenue growth

Growth. It is one of those words that every analyst wants to hear, and every manager wants to deliver. As we covered in the ROIC section though, increased revenues destroy value when investments are made that delivered below cost of capital returns. Research by McKinsey emphasises this balance between ROIC and Revenue growth. If ROIC is low, the company’s share price increases more when its ROIC increases than when its revenue increases. On the other hand, the share price of a high-ROIC company increases more when revenues are increased than when ROIC is improved even further. High ROIC projects in combination with high revenue growth is consequently the sweet-spot for a company in terms of generating value.

Some short facts about revenue growth and value creation

  • Growing by creating new markets through new products, convincing existing customers to buy more of a product, or attracting new customers to the market deliver above average value for every dollar of revenue, since there are either no established competitors, or all competitors benefit from the development. Gaining share from rivals through incremental innovation or promotion and pricing, or making large acquisitions create below average value since competitors can replicate, retaliate or you simply have to pay more than you get. Average value is created using bolt-on, small, acquisitions and gaining market shares in fast growing markets since you pay a reasonable price for what you get, and competition can still grow.
  • Sustaining growth is much harder than sustaining ROIC, simply due to the fact that it becomes impossible to find investments with the type of nominal terms growth you need to continue with the same growth rate in percentage. There are natural life-cycles to product markets, and the slow growing products will ultimately become a part of a company’s portfolio.  
  • As an analyst, do not overestimate the growth phase of a company. Keep in mind this following fact: the median growth period for companies classified as growth companies in the U.S. was according to Damodaran just 3.5 years. McKinsey’s research suggests that companies growing faster than 20 percent typically grew only 8 percent within 5 years and 5 percent within 10 years.
  • Real revenue growth is also fluctuating significantly, much more than ROIC. 

A few words about earnings

Some investors obsess themselves over how the earnings per share (EPS) develops in a company. Sure, companies where there are great earnings trends are most likely also creating value, and furthermore, the value of earnings and cash flows should be equal at as the company’s life goes to infinity. Nevertheless, here follows some information on why ROIC and revenue growth matters more than EPS.

  • Changes in accounting standards does not impact share prices, even thought they often in these changes have impacted earnings. The effect on prices has been due to the cash flow effect of lower taxes, not earnings. For example, when the accounting standards concerning employee stock options changed making the implicit cost of the options expensed on the income statements and lowering earnings, the stock market did not care. It was cash flows that mattered, not reported earnings.
  • Mergers and acquisitions only affect share prices when the value creation changes, not as an effect of EPS change, or due to the fact that the target was bought at a lower P/E ratio than the acquirer was trading at. There was most likely a growth and profitability reason behind the multiple. If you want to know more about the drivers of multiples, check out the “analytical tests” under “relative valuation”.
  • Write-downs of Goodwill do not affect value creation, and thus not share prices. Rational investors look at the underlying cash flows and business fundamentals rather than reported earnings and Goodwill impairments. The stock market normally understands that an acquisition was not value creating from the beginning, and already considered that goodwill probably would be impaired (even though this is not always the case).
  • Earnings volatility does not matter either. Ratios of market value to capital are decreasing with cash flow volatility, but not earnings volatility when having already accounted for the volatility in cash flows. Even the most stable companies have very volatile earnings, much more than you might think.
  • Neither does meeting earnings estimates matter that much. Earnings surprises only account for 2 per cent of the volatility in the four weeks surrounding the announcement.
  • And what about earnings guidance, does it matter? Nope. It has no effect on volatility, higher valuations or market liquidity. Most likely, it is just a cost for companies.

This post was quite long, and maybe a little dry... But I hope it was informative! I will soon post a valuation on a company where management incentives are tied to ROIC, there is a positive profitability trend, but the multiples has not increased with it!