Chapter 3: Value

Lecture 3.1: Value Creation

 No Investment
Use earnings as payout
opportunities within the
to shareholders
company

When is
Positive
results/ cash value
created?
Retain earnings to invest
Investment opportunities and generate higher
within the company earnings in the future to
improve payout
Company A earns $100 million a year in after-tax profit/ in cash flow. Part of the profit/ cash flow will be reinvested in
the business, the remainder distributed to investors.

Financial Terms
$50
Investment Rate (IR) = 50%
Available
Income/ Cash
Flow
= $50
Payout Rate = 50%
$100
Returned
to investors
 A simple answer to this would be saying that companies will create value if they have a high return on the investment
opportunities that they have found

 This implies a higher return would lead to more value being created
 If I hold 600€ today from my company and they give me a 10% return for the next period, that is obviously a better deal than the
same 600€ giving me a 5% return next period.

 Although true, this doesn’t address the issue of when is value created. Is a 1% return enough? Is 10% Is 100%? Is
500%?
 To understand whether or not companies should be investing, we need to consider not only what
the return of that investment is but also what companies would be getting were they to invest
elsewhere – the opportunity cost.

 As it turns out, companies create value by investing capital they raise from investors to generate
future cash flows at rates of return exceeding the cost of capital (i.e., the rate investors require to
be paid for the use of their capital).
VALUE IS CREATED IF COMPANIES FIND INVESTMENT
OPPORTUNITIES WHERE THE RETURN ON THE
INVESTMENTS IS HIGHER THAN THE COST OF
CAPITAL FOR INVESTORS
 The Return on Invested Capital (ROIC) is a measure for the overall return on all capital that has been
invested in the firm

𝑹𝒆𝒔𝒖𝒍𝒕𝑻
𝑹𝑶𝑰𝑪𝑻 =
𝑰𝒏𝒗𝒆𝒔𝒕𝒆𝒅 𝑪𝒂𝒑𝒊𝒕𝒂𝒍𝑻−𝟏

 The Return on New Invested Capital (RONIC) is a measure for the new capital that was invested in the firm,
comparing it only with the incremental impact on cash flow

𝑹𝒆𝒔𝒖𝒍𝒕𝑻 - 𝑹𝒆𝒔𝒖𝒍𝒕𝑻−1
𝑹𝑶𝑁𝑰𝑪𝑻 =
𝑰𝒏𝒗𝒆𝒔𝒕𝒆𝒅 𝑪𝒂𝒑𝒊𝒕𝒂𝒍𝑻−𝟏 − 𝑰𝒏𝒗𝒆𝒔𝒕𝒆𝒅 𝑪𝒂𝒑𝒊𝒕𝒂𝒍𝑻−𝟐
ROIC Percent

ROIC on existing capital

Company-wide ROIC

ROIC on new capital (RONIC)

Which one should be used to asssess value creation – to be compared against the cost of capital?
ROIC Percent

ROIC on existing capital

Company-wide ROIC

ROIC on new capital (RONIC)

 If the cost of capital is equal to 10%, this would mean that new projects are not creating value. Existing projects however would
continue to perform at the level as the initial year!
 ROIC should be used to assess overall value creation for the firm, but keep in mind that will imply a long “history” of investments in
large companies…
 Typically, we are more interested in looking at more recent investments and seeing what growth rate they entail for the company, in
which case RONIC will be the better choice
 IF Return on Investments > Cost of Capital

↑↑↑ Return on ↑↑↑ Amount

↑↑↑Value Creation
Investments Retained/ Invested

↑↑↑ Growth Rate

Is there another way to increase value creation?

 In general, the answer is quite simple: the faster companies can increase their cash flow and
generate more return from the capital they invest, the more value they create.

 This means that provided that the company is in a value generation context, the more they invest,
the better off they will be: the higher the growth at which earnings move, the more value is
created.
 𝐶𝑜𝑟𝑒 𝑅𝑒𝑠𝑢𝑙𝑡𝑇 − 𝐶𝑜𝑟𝑒 𝑅𝑒𝑠𝑢𝑙𝑡𝑇−1
𝑔=
𝐶𝑜𝑟𝑒 𝑅𝑒𝑠𝑢𝑙𝑡𝑇−1

𝐶𝑜𝑟𝑒 𝑅𝑒𝑠𝑢𝑙𝑡𝑇 − 𝐶𝑜𝑟𝑒 𝑅𝑒𝑠𝑢𝑙𝑡𝑇−1 𝐼𝐶𝑇−1 − 𝐼𝐶𝑇−2

𝑔= ×
𝐼𝐶𝑇−1 − 𝐼𝐶𝑇−2 𝐶𝑜𝑟𝑒 𝑅𝑒𝑠𝑢𝑙𝑡𝑇−1

𝒈 = 𝑹𝑶𝑵𝑰𝑪 × 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝑹𝒂𝒕𝒆𝑵𝒆𝒘 𝑪𝒂𝒑𝒊𝒕𝒂𝒍

 𝐶𝑜𝑟𝑒 𝑅𝑒𝑠𝑢𝑙𝑡𝑇 − 𝐶𝑜𝑟𝑒 𝑅𝑒𝑠𝑢𝑙𝑡𝑇−1
𝑔=
𝐶𝑜𝑟𝑒 𝑅𝑒𝑠𝑢𝑙𝑡𝑇−1

𝐶𝑜𝑟𝑒 𝑅𝑒𝑠𝑢𝑙𝑡𝑇 𝐶𝑜𝑟𝑒 𝑅𝑒𝑠𝑢𝑙𝑡𝑇 𝐼𝐶𝑇−1

𝑔= −1= × −1
𝐶𝑜𝑟𝑒 𝑅𝑒𝑠𝑢𝑙𝑡𝑇−1 𝐼𝐶𝑇−1 𝐶𝑜𝑟𝑒 𝑅𝑒𝑠𝑢𝑙𝑡𝑇−1

𝒈 = 𝑹𝑶𝑰𝑪 × 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝑹𝒂𝒕𝒆𝑻𝒐𝒕𝒂𝒍 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 − 𝟏

Growth Investment Rate Growth Investment
= x RONIC = x ROIC - 1
Rate of New Capital Rate Rate

 The growth rate depends on how much it is invested and how much that investment will generate for
the firm.
 Notice how:
 For the same level of return on investment, the more we invest, the higher the growth rate!
 For the same level of investment rate, the higher the return on investment, the higher the growth rate!
 If we know two of parameters, we know the third one.
Are higher value creation drivers always a good thing?
 Yes for ROIC/RONIC
 No for growth

 Companies will only actually be creating value with their investments if they allow investors to achieve a return higher than they
would get elsewhere – higher than the cost of capital.

 The correct answer to: “How does a firm create value?” thus is: Through growth rate or ROIC/RONIC, provided that return on
investment >cost of capital

 So increasing the return on invested capital is always a good thing! But increasing growth rate if return <cost of capital is
actually a bad thing!
Example of Translating Growth and ROIC into Value:

RONIC
132 € 5% 8% 10% 13% 15%
4% -275 € -138 € 0 € 137 € 275 €
Growth 5% -330 € -165 € 0 € 165 € 330 €
6% -412 € -206 € 0 € 206 € 412 €
 When RONIC is higher than the cost of capital, a higher growth will result in a higher value…
 But when RONIC is lower than the cost of capital, a higher growth will actually destroy more value!
 Value is created if we find an investment opportunity whose return (RONIC) is higher than the
alternative use our shareholders might have if we give them their capital back (WACC)

 Assuming we are in a RONIC > WACC situation, the more we invest, the more value we create. As
such, the higher the payout, the less value we are creating, because we are preventing shareholders
to tap into the investment opportunities we have found – we are limiting the growth rate

Growth Rate = (1 – Payout Rate) x RONIC

Drivers of value creation:
ROIC/RONIC
Growth Rate
How is value creation felt in the investment world?

 Example: General Electric’ share price increased from about $5 in 1991 to about $40 in 2001,
earning investors $519 billion, from the increase in share value and distributions, during the final
10 years of Welch’s tenure as CEO. Meanwhile, a similar amount invested in the S&P 500 index
would have returned only $212 billion.

 Industrial business of GE:

Revenues growth: 4% a year (actually less than the growth of the economy!)
ROIC: increased from 13% to 31%
 How should firms manage value creation?

In general, companies
already earning a high ROIC
can generate more
additional value by
increasing their rate of
growth rather than their
ROIC while low ROIC
companies will generate
more value by focusing on
increasing their ROIC

(1) Source: McKinsey Corporate Performance Center Analysis

 Which activities create the most value for a firm?

The big differences here

result from the very
different ROICs,
particularly when it comes
to amount of capital
invested

(1) Source: McKinsey Corporate Performance Center Analysis

 How to evaluate a business’ value creation?
The problem of averages hiding
 The senior leaders of a diversified global industrial company recently got a outliers is a common one when
major shock when they took a more detailed look at corporate performance. assessing value creation and it often
Rather the viewing the company through the usual lens of the top-line undermines the corporate center’s
growth and return on invested capital of its four divisions, the members of ability to take a strategic look across
the top team broke things down much further – into 150 business the organization and make the selective
segments. course correction or trade-offs
between investments.
 They found out that 2/3 of those segments were actually destroying value
An annual budgeting meeting on these
when comparing its ROIC with respective costs of capital.
companies would highlight this, as
 The rest, however, were outperforming by enough to skew the averages for companies tend to allocate their
the company and each division. capital, R&D and marketing budgets to
the same activities year after year,
 Recognizing the performance disparities helped the company identify a set of regardless of their contribution to
opportunities to reallocate resources and stimulate value creation more performance.
than anything it had done previously.

(1) Source: McKinsey on Finance

Bottom Line:

Understanding the sources of value creation will be THE key component to figuring out
the company’s value, and thus being able to successfully invest in the company.

However, understanding these drivers has far more wide-reaching applications than just
as an input to command investment strategy. It should be a key part of any managerial
role.