Companies create value by investing capital to generate future cash flows at rates of return that exceed their cost of capital. The faster they can grow and deploy more capital at attractive rates of return, the more value they create. The mix of growth and return on invested capital (ROIC) relative to the cost of capital is what drives the creation of value. A corollary of this principle is the conservation of value: any action that doesn’t increase cash flows doesn’t create value. Fundamental Principles of Value Creation
The principles imply that a company’s primary task is to generate cash flows at rates of return on invested capital greater than the cost of capital.
Following these principles helps managers decide which investments will create the most value for shareholders in the long term. The principles also help investors assess the potential value of alternative investments. Managers and investors alike need to understand in detail what relationships tie together cash flows, ROIC, and value; what consequences arise from the conservation of value; and how to factor any risks attached to future cash flows into their decision making. These are the main subjects of this chapter. The chapter concludes by setting out the relationships between cash flows, ROIC, and value in the key value driver formula—the equation underpinning discounted cash flow (DCF) valuation in both theory and practice. Fundamental Principles of Value Creation
Growth and ROIC
Companies create value for their owners by investing cash now to generate more cash in the future. The amount of value they 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 today’s because of the time value of money and the riskiness of future cash flows. A company’s return on invested capital and its revenue growth together determine how revenues are converted to cash flows. Fundamental Principles of Value Creation
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. Fundamental Principles of Value Creation
One might expect universal agreement on a notion as fundamental as value, but this isn’t the case: many executives, boards, and financial media still treat accounting earnings and value as one and the same and focus almost obsessively on improving earnings. However, while earnings and cash flow 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. Fundamental Principles of Value Creation
For example, earnings growth alone can’t explain why investors in drugstore chain Walgreens, with sales of $54 billion in 2007, and global chewing-gum maker Wm. Wrigley Jr. Company, with sales of $5 billion the same year, earned similar shareholder returns between 1968 and 2007.3 These two successful companies had very different growth rates. During the period, the net income of Walgreens grew at 14 percent per year, while Wrigley’s net income grew at 10 percent per year. Even though Walgreens was one of the fastest-growing companies in the United States during this time, its average annual shareholder returns were 16 percent, compared with 17 percent for the significantly slower-growingWrigley. The reasonWrigley could create slightly more value than Walgreens despite 40 percent slower growth was that it earned a 28 percent ROIC, while the ROIC for Walgreens was 14 percent (a good rate for a retailer). Fundamental Principles of Value Creation