TL;DR
The guiding principle of value creation is that 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 faster companies can increase their revenues and deploy capital at attractive rates of return, the more value they create. Each incremental unit of capital yields positive marginal gains in cash flow.
The Tao of business value creation:
V = (NOPLAT x [1-g/ROIC])/(WACC-g)
Where:
ROIC > WACC > g > 0
The above inequalities need to be in place for a non-negative valuation.
See main body of article for acronym definitions: NOPLAT, g, ROIC and WACC.
Summary
Not all growth is equal. The most desirable form of growth is of top line revenue growth driven by either product, market or customer expansion accompanied by improving overall operating margins due to increased operational efficiency that translates into improved cashflows.
The guiding principle of value creation is that 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 faster companies can increase their revenues and deploy capital at attractive rates of return, the more value they create. Each incremental unit of capital yields positive marginal gains in cash flow.
V = (NOPLAT x [1-g/ROIC])/(WACC-g)
To unpack the valuation formula we can use value driver trees on the various factors influencing a valuation to increase our understanding of the underlying factors driving value.
Some management rules of thumb:
Conservation of Value - A basic management rule of thumb is the following, any management action that does not increase cash flow does not increase value
Value Destruction - When ROIC is lower than a company’s cost of capital (i.e., WACC > ROIC), faster growth necessarily destroys value
Focus on ROIC before Growth - If a company has a high ROIC and is greater than the cost of capital (i.e., ROIC > WACC), focusing on growth will increase value exponentially versus when ROIC is less than cost of capital captured via WACC
ROIC > WACC > g > 0
To increase an organisation’s valuation you need to improve either ROIC or revenue growth that translates into cash flow. Improving ROIC though is more important than growing revenue but the magic happens when you can do both.
The most valuable forms of revenue growth come from creating new products and new markets (e.g., Blue Ocean Strategy) and attracting new customers to a market. In the middle are bolt-on acquisitions. The least valuable forms of revenue growth come from large acquisitions and market share battles based on marketing, pricing, and incremental product updates.
Article
The story of pricing would not be complete without having a discussion on some corporate finance concepts like Valuation and the factors driving enterprise value like Return on Invested Capital (ROIC), Weighted Average Cost of Capital (WACC) and growth.
My earlier articles spoke about the link of pricing and value creation as well as pricing models and revenue leakage. This article will look at how corporate financial valuation is driven from key performance indicators like cash flow, growth and the ability of a business to reinvest into initiatives with economic profit (i.e., accounting for opportunity costs through an appropriate capital charge).
This article will be corporate finance and math equation heavy but this is needed to convey key concepts and handle some foundational issues. I guess you can argue my time in investment banking and management consulting was not wasted.
One could easily be forgiven for thinking that growth is the number one business priority… though the recent market downturn (circa 2022) is beginning to show that not all growth reflects sound economic fundamentals.
Not all growth is equal. The most desirable form of growth is of top line revenue growth driven by either product, market or customer expansion accompanied by improving overall operating margins due to increased operational efficiency that translates into improved cashflows. This is the stuff business dreams are made of…
The below paragraphs will help to unpack the above paragraph. To understand valuation, we need to create a shared foundation of understanding.
Economic Value Creation
The guiding principle of value creation is that 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 cost of capital is the rate of return investors require to be paid for the use of their capital relative to alternatives like ‘risk-free’ government bonds).
The faster companies can increase their revenues and deploy capital at attractive rates of return, the more value they create. Each incremental unit of capital yields positive marginal gains in cash flow.
Valuation is a way to show how key business outcomes and drivers are systematically linked. The formula below given a few simplifying assumptions can be used to show how valuations are driven.
V = (NOPLAT x [1-g/ROIC])/(WACC-g)
Note: The above formula can be derived from first principles. For reference see T.E. Copeland and J. Fred Weston, Financial Theory and Corporate Policy, 3rd ed. (Reading, MA: Addison Wesley, 1988), Appendix A.
Value is a numerical value denominated in currency terms. So a business owner if generating positive cashflows and applying an ‘appropriate’ capital charge to those cash flows would have a non-negative value that they could receive if they sold their business.
Where:
Value (V)
Net Operating Profit Less Adjusted Taxes (NOPLAT)
Revenue growth (g)
Return on Invested Capital (ROIC)
Weighted Average Cost of Capital (WACC)
For the valuation formula to be used by practitioners a few of the assumptions need to be relaxed. Nevertheless, it gives a useful first approximation for understanding how a business generates business value in a structured and systemic way and not through pushing for value-destroying growth at all costs.
NB. To sum up value is driven by expected cash flows discounted with an appropriate capital charge. Cash flow in turn is a function of expected operating profit, returns on invested capital and revenue growth.
Financial Valuation Driver Tree
In more recent years you could argue that investors in start-ups have been willing to give founders the benefit of the doubt by capitalising start-up valuations highly and giving some ventures really questionable valuations. The difficulty of having a stratospheric valuation is investors were assuming flawless execution for these start-ups to grow into.
To unpack the valuation formula we can use a value driver tree to increase our understanding of the underlying factors driving value.
Net Operating Profit Less Adjusted Taxes (NOPLAT)
Revenue growth (g)
Return on Invested Capital (ROIC)
Note: The drivers of g and ROIC are contextual and industry specific.
Weighted Average Cost of Capital (WACC)
Management Rules of Thumb
Conservation of Value: A basic management rule of thumb is the following, any management action that does not increase cash flow does not increase value
Value Destruction: When ROIC is lower than a company’s cost of capital (i.e., WACC > ROIC), faster growth necessarily destroys value
Focus on ROIC before Growth: If a company has a high ROIC and is greater than the cost of capital (i.e., ROIC > WACC), focusing on growth will increase value exponentially versus when ROIC is less than cost of capital captured via WACC
Key Inequalities
If you want a valuation that is non-negative then the following inequalities need to be obeyed.
NOPLAT > 0
For 1-(g/ROIC) > 0 requires ROIC > g
For WACC-g > 0 requires WACC > g
ROIC > WACC > 0
Implications for Product Developers
Growth, while still a key driver of value, needs to be seen for what it is; an accelerator of value that’s best pursued when return on invested capital is high.
Companies can set targets however targets are not a strategy; I will not discuss strategy in depth in this article but will reference strategy ideas from leading thinkers. The works of Roger Martin and Richard Rumelt share compelling perspectives on what strategy is.
To increase an organisation’s valuation you need to improve either ROIC or revenue growth that translates into cash flow. Improving ROIC though is more important than growing revenue but the magic happens when you can do both.
Revenue growth that preserves ROIC leads to long-term value creation. The authors of the McKinsey classic finance book, Value, rank the unique types of revenue growth in terms of their ability to generate long-term value creation.
The most valuable forms of revenue growth come from creating new products and new markets (e.g., Blue Ocean Strategy) and attracting new customers to a market. In the middle are bolt-on acquisitions. The least valuable forms of revenue growth come from large acquisitions and market share battles based on marketing, pricing, and incremental product updates.
Building wholly new products and developing new markets are the fundamental building blocks of long-term value creation. Business development, marketing, and product management are important, but they support — and not overtake (as often happens in large companies) — the company’s strategy, innovation, and R&D engines.
In 2018, McKinsey’s strategy practice determined the relative impact of growth and ROIC on economic profit.
In short, the general odds are 8% for a company to move from being in the middle to being a top performer. But the odds of doing so are 19% if you outperform in both ROIC and revenue growth.
Outperforming on ROIC alone (e.g., becoming more cost efficient without growing) keeps you at 8%. Outperforming on growth but underperforming on ROIC (e.g., scaling your business when you are not ready to do so efficiently), has just a 4% chance of upward mobility — and it comes with a 25% chance of slipping into being a bottom performer.
Whereas growth is a fleeting metric, ROIC is far more sustainable. McKinsey metrics taken from the 500 top publicly listed US companies from 1965,1975,1985, and 1995, for example, show that companies were far more successful at maintaining their ROIC over time than their rate of growth.
Despite being stable, ROIC also has a much more direct effect on company value than growth, mainly because it directly impacts an organization’s cash flow.
Pragmatic areas to focus on to drive cash flow
In order to drive value, CFOs, CEOs, and other company executives need to find opportunities to maximize ROIC. To do this, it can help to review your cycle time and find ways to speed up the time it takes for your company to generate returns. Some business variables impacted by cycle time worth looking at include:
Working capital: How much inventory does the company have vs. how much does it need? How efficient is its supply chain and collections process?
Time to value: How long does it take for new investments to start generating returns?
Credit utilization rate: How much debt does your company have and what are its credit limits?
Competitive advantages can be analyzed from either a production or consumption viewpoint. A company has a production advantage when it can supply goods and services at a lower price than competitors are able to match. It has an advantage from a consumption perspective when it can supply goods or services difficult for other competitors to imitate.
The follow-up to this article will look at the question if these techniques can be applied to high growth scale-ups?
Post Script
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Resources
Revenue growth and ROIC are all that matter
Return on Invested Capital and Growth: Key Value Drivers
Valuation by Tim Koller, Marc Goedhart and David Wessels