This chapter discusses return on invested capital (ROIC) and growth as fundamental drivers of company value. It provides the following key points: 1. ROIC measures a company's ability to generate returns from its capital investments and should be compared to its cost of capital and returns on alternative investments. 2. The value creation formula shows that higher long-term ROIC and growth rates lead to greater company value. 3. Sustainable competitive advantages allow some companies to maintain high ROIC for extended periods, while others see ROIC decline over time as advantages erode. 4. Empirical analysis shows ROIC and growth tend to decrease as companies mature, with 50% of high-ROIC companies

1. Chapter 5: Thinking about Return on
Invested Capital & Growth

2. Table of Content
1.ROIC as a fundamental Driver of Value
2.Framework for Value Creation
3.An Empirical Analysis of ROIC
4. ROIC by Industry, Size & Growth
5. Decay Analysis
6. Closing Thoughts

3. 1.ROIC as a fundamental Driver of Value
 A company can be analyzed in various ways, by using Revenue, Net
Income and Asset Growth but all of these cannot be used individually
hence the Net Income must be precisely matched with Invested Capital.
 ROIC is the most used company measure and not only allows companies
to compare their success with invested capital but also assess its return
relative to capital investment risk
 It also compares returns on invested capital to return on alternative
investments.

4. 1.1 An Insight into calculating ROIC

5. 1.1 ROIC and Growth
 By focusing on ROIC and growth, forecasts can be placed in proper context.
 While forecasting a valuation model, projections must fit with the capabilities of the company and the
competitive dynamics of the industry.
 As seen from Figure 1 below, it is assumed that cost of capital for a hypothetical firm equals 10% and
current revenues equal $1 Billion, otherwise making no other projections. Using the Enterprise DCF
method and values solely from Fig 1, the company is valued and projection are as shown in Figure 2
Figure 1: The fundamental Drivers of
Value

6. 1.1 ROIC and Growth
Figure 2: Valuation Based on
Fundamentals

7. Home Depot and Lowe’s Return on Invested Capital
Analyze Historical Performance
• Before projecting future cash
flow, examine the company’s
historical performance. A good
analysis focuses on the key
drivers of value: return on
invested capital (ROIC) and
growth. ROIC measures a
company’s ability to create value.
• Both Home Depot and Lowe’s
have struggled to maintain ROIC
in recent years. Home Depot no
longer enjoys a performance
advantage over Lowe’s.
How do we compute ROIC?
percent
1
ROIC measured with goodwill and acquired intangibles. Goodwill and acquired intangibles
do not meaningfully affect ROIC for either company.
0
5
10
15
20
2000 2001 2002 2003 2004 2005 2006 2007 2008
Home
Depot
Lowe's
1.2 Analyze Historical Performance: Analyzing ROIC
7

8. 2.0 Framework for Value Creation –
Relevance of ROIC
• The formula above is a simple yet powerful and is known as
the “Value Driver Formula”.
• The underlying assumption is that cash flow growth is
perpetual and formulates a direct relationship between
ROIC and Growth (g).
Assuming that a company’s
cash flow will grow at a
constant rate forever.
Value creation formula for established
firms

9. 2.1 Understanding the components of Value Creation –
Peak ROIC
o Expressed the traditional definition of ROIC = NOPLAT/ Invested Capital
o The ratio is segmented in Tax (T), revenue and cost per unit, quantity to
highlight potential sources of value creation while we value a company.
o There are various questions which crop up after looking at this formula :
 Does the company have lower unit cost than competitors?
 Can the company sell more products per dollar of invested capital ?
To answer the above questions and to justify high future ROIC , at least
one source of competitive advantage must be identified.

10. 2.2 Identifying sources of competitive
advantage for a firm

11. 2.2.1 Examples of Peak ROIC and
Sustainability
Source: Kaplan
Financial
Figure 3: General Model of Value Creation

12. 2.2.1 Examples of Peak ROIC and
Sustainability
 Figure 3 reflects a general pattern for ROIC and Sustainability.
 It is flexible and can be used to describe different companies
 Reflect companies with Peak ROIC but are less sustainable and also companies who
have peak ROIC near the cost of capital yet can generate excess returns over an
extended period of time.
 Examples are “Intel” and “Johnson and Johnson”.
 Starting from 1973, during its initial stage Intel was a pioneer in the computer chips
and store data or RAM chips industry. After creating value for a period of 10 Years, it
succumbed to pressure but later regained momentum.
 Economic Theory dictates that firm who are able to create excess returns compared
with their cost of capital invite competition.

13. 2.3 Recouping Initial Investments or Early
Losses
A few questions which crop up when a company fails to earn returns in
excess of their cost of capital are :
Q1 How long will it take before the company starts creating value ?
Q2 How large will the initial investments (or losses) be ?
Figure 4 : ROIC Projections: Value Destruction at Young
Companies

14. 3.0 An Empirical Analysis of ROIC
Source: Mckinsey

15. 4.0 ROIC by Industry Group
Source: Mckinsey’s, Valuation (2005, p.148)

16. 4.1 ROIC Segmented by Size and Revenue
Growth

17. 4.2 Empirical Analysis of ROIC
We have examined a general model of value
creation using economic theory and case studies.
But how does ROIC and growth behave on an
aggregate empirical basis?

18. 5.0 ROIC Decay Rates
 In cases where ROIC > Cost of Capital

19. 5.1 ROIC Transition Probability
Percent, 3-year average of ROIC without
goodwill
43% of companies
with ROIC of <5% in
1994 still have an
ROIC of <5%, 10
years later
Companies with
ROIC’s between 10%
& 20% show little
persistence, landing in
any group with an
equal probability
50% of companies
with ROIC >20%
in 1994 still have
ROIC of >20%, 10
years down the
line

20. 5.2 Empirical Analysis of Corporate Growth
 We have examined how ROIC behaves over time. But does corporate revenue growth has an
impact ? Or does revenue growth behave as an aggregate empirical basis ?

21. Questions?
Chapter 2. Fundamental Principles of Value Creation
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