Value Creation and ROIC (Return on Invested Capital)

compartir

In Mexico, many business people believe that their companies can obtain profits in the long term by only growing sales in a fast way without understanding quite well the concept of value creation.

Companies create value when they perform actions that increase the worth of goods and services.

There are two ways to measure value creation; the first one is growth and the second one is through ROIC (return on invested capital).

Growth is easy to explain and easy to see inside the companies. When there is more demand for products and services therefore production increases, employers hire more people and more CAPEX (investment in equipment, machinery and working capital) is needed .

Then return on invested capital (ROIC) another measure for value creation, represents what will be the yield that a company obtains after investing in capital. This can be obtained with the following formula:

Net Operating Profit After Taxes (NOPAT) / Total Invested Capital

So at the end, this ratio shows a yield or return that a company gets after investing money in equipment, machinery and or working capital.

Also, another way to understand growth is by multiplying ROIC times investment rate.

Growth = ROIC * Investment rate

According to some ex-McKinseys consultants, the more growth and capital deployment at attractive rates of return, the more value they create. The combination of growth and return on invested capital (ROIC), at higher rates compared to its cost of capital (WACC), is what drives and creates real value for a company.

Besides some studies made by a prestigious consulting firm demonstrate that investments in research and development (R&D) correlate with positive long-term returns to shareholders and therefore creating value to the company.

Another concept to be addressed is cost of capital. In this section we will not explain WACC or cost of capital in more detail but it is important to consider it in order to determine the value of a company:

Value = Free Cash Flow year 1 / (WACC or cost of capital – growth rate)

Free cash flow is the cash flow generated by the business, or “money left in the pocket”. In the other hand, growth rate is the rate at which the company’s NOPAT, Net Income and cash flow grow each year.

Another pattern is that many companies, especially in Mexico, only focus on the short-term. Decision makers should make decisions for the long-term, even if that means making some sacrifices. When businesses only focus in the short term that is a formula for disaster. The result throughout history is a financial crisis.

Annualized TRS. 1996-2005. %

Growth                     Change in ROIC
Below Average      Decreased
Below Average      Increased
Above Average      Decreased
Above Average      Increased
 
 

Source: Bin Jiang and Tim Koller, “How to Choose between Growth and ROIC”. McKinsey on Finance, no. 25 (Autumn 2007) 19-22.

Publicado por: Francisco Montalvo