Disaggregating cash flow into revenue growth and ROIC helps illuminate the underlying drivers of a company’s performance. Say a company’s cash flow was $100 last year and will be $150 next year. This doesn’t tell us much about its economic performance, since the $50 increase in cash flow could come from many sources, including revenue growth, a reduction in capital spending, or a reduction in marketing expenditures. But if we told you that the company was generating revenue growth of 7 percent per year and would earn a return on invested capital of 15 percent, then you would be able to evaluate its performance. You could, for instance, compare the company’s growth rate with the growth rate of its industry or the economy, and you could analyze its ROIC relative to peers, its cost of capital, and its own historical performance.
Growth, ROIC, and cash flow are tightly linked. To see how, 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.
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. Relationship of Growth, ROIC, and Cash Flow
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. For both companies, discount each year’s cash flow to the present at a 10 percent cost of capital and summed the results to derive a total present value of all future cash flows: $1,500 million for Value Inc. and $1,000 million for Volume Inc.
The companies’ values can also be expressed as price-to-earnings ratios (P/Es). To do this, divide each company’s value by its first-year earnings of $100 million. Value Inc.’s P/E is 15, while Volume Inc.’s is only 10. Despite identical earnings and growth rates, the companies have different earnings multiples because their cash flows are so different. Relationship of Growth, ROIC, and Cash Flow
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)1. 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% Relationship of Growth, ROIC, and Cash Flow
Since the three variables are tied together, you only need two to know the third, so you can describe a company’s performance with any two of the variables.
Balancing ROIC and Growth to Create Value
The table above shows how different combinations of growth and ROIC translate into value. Each cell in the matrix represents the present value of future cash flows under each of the assumptions of growth and ROIC, discounted at the company’s cost of capital. In this case, we’re assuming a 9 percent cost of capital and a company that earns $100 in the first year2. Relationship of Growth, ROIC, and Cash Flow
Using this simple approach, we get real-world results. Take the typical large company, which grows at about 5 to 6 percent per year (nominal), earns about a 13 percent return on equity, and has a 9 percent cost of capital. Finding the intersection of the typical company’s return leads you to a value of $1,500 to $1,600. Dividing this value by earnings of $100 results in a price-to-earnings ratio of 15 to 16 times—and 15 times is the median P/E for large U.S. companies outside of a recession. Relationship of Growth, ROIC, and Cash Flow
Observe that for any level of growth, value increases with improvements in ROIC. In other words, when all else is equal, a higher ROIC is always good. The same can’t be said of growth. 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. On the line, value is neither created nor destroyed, regardless of how fast the company grows. Relationship of Growth, ROIC, and Cash Flow
Sometimes it is argued that even low-ROIC companies should strive for growth because if a company grows, its ROIC will naturally increase. However, this is true only for young, start-up businesses. Most often in mature companies, a low ROIC indicates a flawed business model or unattractive industry structure. Relationship of Growth, ROIC, and Cash Flow
Real-World Evidence Relationship of Growth, ROIC, and Cash Flow
General Electric (GE) provides another example of the relative impact of growth and ROIC on value. GE’s 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 JackWelch’s tenure as CEO. A similar amount invested in the S&P 500 index would have returned only $212 billion.
How did GE do it? Its industrial and finance businesses both contributed significantly to its overall creation of value, but in different ways. Over the 10-year period, the industrial businesses increased revenues by only 4 percent a year (less than the growth of the economy), but their ROIC increased from about 13 percent to 31 percent. The finance businesses performed in a more balanced way, demonstrating growth of 18 percent per year and increasing ROIC from 14 percent to 21 percent. In the industrial businesses, ROIC was the key driver of value, while in the financial businesses, improvements in both growth and ROIC contributed significantly to value creation.
Clearly, the core valuation principle applies at the company level. We have found that it applies at the sector level, too. Consider companies as a whole in the consumer packaged-goods sector. Even though well-known names in the sector such as Procter & Gamble and Colgate-Palmolive aren’t high-growth companies, the market values them at high earnings multiples because of their high returns on invested capital.
The typical large packaged-goods company increased its revenues only 6 percent a year from 1998 to 2007, slower than the average of about 8 percent for all large U.S. companies. Yet at the end of 2007 (before the market crash), the median P/E of consumer packaged-goods companies was about 20, compared with 17 for the median large company. The high valuation of companies in this sector rested on their high ROICs—typically above 20 percent, compared with ROICs averaging 13 percent for the median large company between 1998 and 2007.
Another example that underlines the point is a comparison of Campbell Soup Company ($8 billion in 2008 revenues) with fast-growing discount retailer Kohl’s (revenues of $16 billion in 2008). In the middle years of the decade, revenues for Kohl’s grew 15 percent annually, while Campbell achieved only 4 percent in annual organic growth. Yet the two companies had similar P/Es. Campbell’s high ROIC of 50 percent made up for its slower growth; Kohl’s ROIC averaged only 15 percent. Relationship of Growth, ROIC, and Cash Flow
To test whether the core valuation principle also applies at the level of countries and the aggregate economy, we asked why large U.S.-based companies typically trade at higher multiples than large companies in the more developed Asian countries of Hong Kong, South Korea, Taiwan, and Singapore3. Some executives assume the reason is that investors are simply willing to pay higher prices for U.S. companies (an assumption that has prompted some non-U.S. companies to consider moving their share listing to the New York Stock Exchange in an attempt to increase their value). But the real reason U.S. companies trade at higher multiples is that they typically earn higher returns on invested capital. The median large U.S. company earned a 16 percent ROIC in 2007, while the median large Asian company earned 10 percent. Of course, these broad comparisons hide the fact that some Asian sectors and companies—for example, Toyota in automobiles—outperform their U.S. counterparts. But for the most part, Asian companies historically have focused more on growth than profitability or ROIC, which explains the large difference between their average valuation and that of U.S. companies. Relationship of Growth, ROIC, and Cash Flow