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Cloth edition: ISBN 978-1-118-87370-0

Cloth edition with DCF Model Download: ISBN 978-1-118-87368-7

University edition: ISBN 978-1-118-87373-1

Workbook: ISBN 978-1-118-87387-8

DCF Model Download: ISBN 978-1-118-87366-3

About the Authors

Preface

Why This Book

Structure of the Book

Valuation Spreadsheet

Acknowledgments

Part One: Foundations of Value

1: Why Value Value?

What Does It Mean to Create Shareholder Value?Can Stakeholder Interests Be Reconciled?

Shareholder Capitalism Cannot Solve All Social IssuesConsequences of Forgetting Value-Creation PrinciplesShort-Termism Runs Deep

This BookReview QuestionsNotes

2: Fundamental Principles of Value Creation

The Relationship of Growth, ROIC, and Cash FlowBalancing ROIC and Growth to Create Value

Real-World ExamplesManagerial ImplicationsEconomic Profit Combines ROIC and SizeThe Math of Value Creation

SummaryReview QuestionsNotes

3: Conservation of Value and the Role of Risk

Conservation of ValueRisk and Value CreationSummary

Review QuestionsNotes

4: The Alchemy of Stock Market Performance

Why Shareholder Expectations Become a Treadmill

Real-World Effects of the Expectations Treadmill

5: The Stock Market Is Smarter Than You Think

Markets and Fundamentals: A Model

Markets and Fundamentals: The Evidence

What about Earnings?

Earnings Management

Diversification and the Conglomerate Discount

Size and Value

Market Mechanics Don't Matter

Value Creation Is More Important than Value DistributionSummary

Review Questions

Notes

6: Return on Invested Capital

What Drives ROIC?

Competitive Advantage

Sustainability of Return on Invested Capital

An Empirical Analysis of Returns on Invested Capital

Summary

Review Questions

Notes

7: Growth

Drivers of Revenue Growth

Growth and Value Creation

Why Sustaining Growth Is Hard

Empirical Analysis of Corporate Growth

Summary

Review Questions

Notes

Part Two: Core Valuation Techniques

8: Frameworks for Valuation

Enterprise Discounted Cash Flow Model

Economic-Profit-Based Valuation Models

Adjusted Present Value Model

Capital Cash Flow Model

Cash-Flow-to-Equity Valuation Model

Other Approaches to Discounted Cash Flow

Alternatives to Discounted Cash Flow

Summary

Review Questions

Notes

9: Reorganizing the Financial Statements

Reorganizing the Accounting Statements: Key ConceptsReorganizing the Accounting Statements: In PracticeAdvanced Issues

Review Questions

Notes

10: Analyzing Performance

Analyzing Returns on Invested Capital

Analyzing Revenue Growth

Credit Health and Capital Structure

General Considerations

Review Questions

Notes

11: Forecasting Performance

Determine the Forecast's Length and Detail

Components of a Good Model

Mechanics of Forecasting

Additional Issues

Review Questions

Notes

12: Estimating Continuing Value

Recommended Formula for DCF Valuation

Continuing Value Using Economic Profit

Subtleties of Continuing Value

Common Pitfalls

Evaluating Other Approaches to Continuing Value

Advanced Formulas for Continuing Value

Closing Thoughts

Review Questions

Notes

13: Estimating the Cost of Capital

Weighted Average Cost of Capital

Estimating the Cost of Equity

Estimating the After-Tax Cost of Debt

Using Target Weights to Determine the Cost of Capital

Complex Capital Structures

Closing Thoughts

Review Questions

Notes

14: Moving from Enterprise Value to Value per Share

Valuing Nonoperating Assets

Valuing Debt and Debt Equivalents

Valuing Hybrid Securities and Noncontrolling Interests

Estimating Value per Share

Review Questions

Notes

15: Analyzing the Results

Validating the Model

Value Multibusiness Companies as a Sum of Their Parts

Use Forward Earnings Estimates

Use Net Enterprise Value Divided by Adjusted EBITA or NOPLATAdjust for Nonoperating Items

Use the Right Peer Group

Valuing by Parts: Mechanics and Insights

Building Business Unit Financial Statements

Valuing Deferred Taxes

Closing Thoughts

Review Questions

Notes

19: Nonoperating Items, Provisions, and Reserves

Nonoperating Expenses and One-Time Charges

Provisions and Their Corresponding Reserves

21: Alternative Ways to Measure Return on Capital

Value-Based Returns on Capital: ROIC and CFROI

Capitalizing Expensed Investments

When Businesses Need Little or No Capital

Summary

Review Questions

Notes

22: Inflation

Inflation Leads to Lower Value Creation

Historical Analysis in Times of High Inflation

Financial Projections in Real and Nominal Terms

Summary

Review Questions

Notes

23: Cross-Border Valuation

Forecasting Cash Flows

Estimating the Cost of Capital

Incorporating Foreign-Currency Risk in the ValuationUsing Translated Foreign-Currency Financial StatementsSummary

Review Questions

Notes

24: Case Study: Heineken

Reorganizing Financial Statements

Analyzing Historical Performance

Forecasting Performance

Estimating Cost of Capital

Estimating Continuing Value

Calculating and Interpreting Results

Notes

Part Four: Managing for Value

25: Corporate Portfolio Strategy

What Makes an Owner the Best

The Best-Owner Life Cycle

Dynamic Portfolio Management

The Myth of Diversification

Constructing the Portfolio

Summary

Review Questions

Notes

26: Performance Management

Adopting a Granular Perspective

Choosing the Right Metrics

Organizational Support

Summary

Review Questions

Notes

27: Mergers and Acquisitions

Value Creation Framework

Empirical Results

Archetypes for Value-Creating Acquisitions

More Difficult Strategies for Creating Value from AcquisitionsEstimating Operating Improvements

How to Pay: In Cash or in Stock?

Focus on Value Creation, Not Accounting

Characteristics of Better Acquirers

Summary

Review Questions

Notes

28: Divestitures

Value Creation from Divestitures

Why Executives Shy Away from Divestitures

Assessing Potential Value from Divestitures

Deciding on Transaction Type

Deciding on Payout and Financing

Creating Value from Financial Engineering

A Comprehensive Case Example

Summary

Review Questions

Notes

30: Investor Communications

Objectives of Investor Communications

Intrinsic Value vs Market Value

Which Investors Matter?

Communicating with Intrinsic Investors

Forecasting Cash Flows

Incorporating Country Risk in Scenario DCF ValuationEstimating Cost of Capital in Emerging Markets

Calculating and Interpreting Results

Summary

Review Questions

Notes

32: Valuing High-Growth Companies

A Valuation Process for High-Growth Companies

Uncertainty Is Here to Stay

An Approach to Valuing Cyclical Companies

Implications for Managing Cyclical Companies

Principles of Bank Valuation

Complications in Bank Valuations

Methods for Valuing Flexibility

Four Steps to Valuing Flexibility

Real-Option Valuation and Decision Tree Analysis: A Numerical ExampleSummary

Enterprise Discounted Cash Flow

Adjusted Present Value

Notes

Appendix C: Levering and Unlevering the Cost of Equity

Unlevered Cost of Equity

Levered Cost of Equity

Levered Beta

Appendix D: Leverage and the Price-to-Earnings Multiple

Step 1: Defining Unlevered P/E

Step 2: Linking Net Income to NOPLAT

Step 3: Deriving Levered P/E

Appendix E: Other Capital Structure Issues

Pecking-Order Theory

Market-Based Rating Approach

Leverage, Coverage, and Solvency

About the Authors

The authors are all current or former consultants of McKinsey & Company's finance practice Collectively they have more than 70 years of experience in consultingand financial education

corporate-Tim Koller is a partner in McKinsey's New York office, where he leads a global team of

corporate-finance expert consultants In his 30 years in consulting, Tim has served clientsglobally on corporate strategy and capital markets, mergers and acquisitions (M&A)

transactions, and value-based management He leads the firm's research activities in

valuation and capital markets Before joining McKinsey, he worked with Stern Stewart &Company and with Mobil Corporation He received his MBA from the University of

Chicago

Marc Goedhart is a senior expert in McKinsey's Amsterdam office and leads the firm's

Corporate Performance Center in Europe Over the past 20 years, Marc has served clientsacross Europe on portfolio restructuring, capital markets, and M&A transactions He

taught finance as an assistant professor at Erasmus University in Rotterdam, where healso earned a PhD in finance

David Wessels is an adjunct professor of finance at the Wharton School of the

University of Pennsylvania Named by Bloomberg Businessweek as one of America's top

business school instructors, he teaches courses on corporate valuation and private equity

at the MBA and executive MBA levels David is also a director in Wharton's executiveeducation group, serving on the executive development faculties of several Fortune 500companies A former consultant with McKinsey, he received his PhD from the University

of California at Los Angeles

McKinsey & Company is a global management-consulting firm that serves leading

businesses, governments, nongovernmental organizations, and not-for-profits across awide range of industries and functions, helping them make distinctive, lasting, and

substantial improvements in performance and realize their most important goals

McKinsey consultants serve clients in every region from a network of over 100 offices inmore than 60 countries, advising on topics including strategy, finance, operations,

organization, technology, marketing and sales, risk, and sustainability and resource

productivity

The 25 years since that first edition have been a remarkable period in business history,and managers and investors continue to face opportunities and challenges emerging from

it The events of the economic crisis that began in 2007, as well as the Internet boom andits fallout almost a decade earlier, have strengthened our conviction that the core

principles of value creation are general economic rules that continue to apply in all

market circumstances Thus, the extraordinarily high anticipated profits represented bystock prices during the Internet bubble never materialized, because there was no “neweconomy.” Similarly, the extraordinarily high profits seen in the financial sector for thetwo years preceding the start of the 2007–2009 financial crisis were overstated, as

subsequent losses demonstrated The laws of competition should have alerted investorsthat those extraordinary profits couldn't last and might not be real

Over time we have also seen confirmed that for some companies, some of the time, thestock market may not be a reliable indicator of value Knowing that value signals from thestock market may occasionally be unreliable makes us even more certain that managersneed at all times to understand the underlying, intrinsic value of their company and how

it can create more value In our view, clear thinking about valuation and skill in usingvaluation to guide business decisions are prerequisites for company success

Today, after six years of sluggish recovery in the United States and stagnation in Europe,calls mount for changes in the nature of shareholder capitalism We find that the blamefor a poorly performing economy should not be placed on the pursuit of shareholder

value creation, but on a misguided focus on short-term performance that is inconsistentwith the value-creation principles we describe in this book Creating value for

shareholders does not mean pumping up today's share price It means creating value forthe collective of current and future shareholders by applying the techniques explained inthis book

Why This Book

Not all CEOs, business managers, and financial managers possess a deep understanding

of value, although they need to understand it fully if they are to do their jobs well andfulfill their responsibilities This book offers them the necessary understanding, and itspractical intent reflects its origin as a handbook for McKinsey consultants We publish itfor the benefit of current and future managers who want their companies to create value,and also for their investors It aims to demystify the field of valuation and to clarify the

linkages between strategy and finance So while it draws on leading-edge academic

thinking, it is primarily a how-to book and one we hope you will use again and again This

is no coffee-table tome: if we have done our job well, it will soon be full of underlining,margin notations, and highlighting

The book's messages are simple: Companies thrive when they create real economic valuefor their shareholders Companies create value by investing capital at rates of return thatexceed their cost of capital These two truths apply across time and geography The bookexplains why these core principles of value creation are genuine and how companies canincrease value by applying them

The technical chapters of the book aim to explain, step-by-step, how to do valuation well

We spell out valuation frameworks that we use in our consulting work, and we illustratethem with detailed case studies that highlight the practical judgments involved in

developing and using valuations Just as important, the management chapters discusshow to use valuation to make good decisions about courses of action for a company

Specifically, they will help business managers understand how to:

Decide among alternative business strategies by estimating the value of each strategicchoice

Develop a corporate portfolio strategy, based on understanding which business units acorporate parent is best positioned to own and which might perform better under

someone else's ownership

Assess major transactions, including acquisitions, divestitures, and restructurings.Improve a company's performance management systems to align the organization'svarious parts to create value

Communicate effectively with investors, including whom to talk with and listen to,and how

Design an effective capital structure to support the corporation's strategy and

minimize the risk of financial distress

Structure of the Book

In this sixth edition, we continue to expand the practical application of finance to realbusiness problems, reflecting the economic events of the past decade, new developments

in academic finance, and the authors' own experiences The edition is organized in sixparts, each with a distinct focus

Part One, “Foundations of Value,” provides an overview of value creation We make thecase that managers should focus on long-term value creation for current and future

shareholders, not just some of today's shareholders looking for an immediate pop in theshare price We explain the two core principles of value creation: (1) the idea that return

on invested capital and growth drive cash flow, which in turn drives value, and (2) the

conservation of value principle, which says that anything that doesn't increase cash flowdoesn't create value (unless it reduces risk) We devote a chapter each to return on

invested capital and to growth, including strategic principles and empirical insights

Part Two, “Core Valuation Techniques,” is a self-contained handbook for using discountedcash flow (DCF) to value a company The reader will learn how to analyze historical

performance, forecast free cash flows, estimate the appropriate opportunity cost of

capital, identify sources of value, and interpret results We also show how to use

multiples of comparable companies to supplement DCF valuations

Part Three, “Advanced Valuation Techniques,” explains how to analyze and incorporate inyour valuation such complex issues as taxes, pensions, reserves, inflation, and foreigncurrency Part Three also includes a comprehensive case valuing Heineken N.V., the

Dutch brewer, illustrating how to apply both the core and advanced valuation techniques.Part Four, “Managing for Value,” applies the value-creation principles to practical

decisions that managers face It explains how to design a portfolio of businesses; how tocreate value through mergers, acquisitions, and divestitures; how to construct an

appropriate capital structure; and how companies can improve their communicationswith the financial markets

Part Five, “Special Situations,” is devoted to valuation in more complex contexts It

explores the challenges of valuing high-growth companies, companies in emerging

markets, cyclical companies, and banks In addition, it shows how uncertainty and

flexibility affect value, and how to apply option-pricing theory and decision trees in

valuations

Valuation Spreadsheet

An Excel spreadsheet valuation model is available via Web download This valuation

model is similar to the model we use in practice Practitioners will find the model easy touse in a variety of situations: mergers and acquisitions, valuing business units for

restructuring or value-based management, or testing the implications of major strategicdecisions on the value of your company We accept no responsibility for any decisionsbased on your inputs to the model If you would like to purchase the model (ISBN 978-1-118-87366-3 or ISBN 978-1-118-87374-8), please call (800) 225-5945, or visit

www.wileyvaluation.com

No book is solely the effort of its authors This book is certainly no exception, especiallysince it grew out of the collective work of McKinsey's corporate-finance practice and theexperiences of its consultants throughout the world

Most important, we would like to thank Tom Copeland and Jack Murrin, two of the

coauthors of the first three editions of this book We are deeply indebted to them for

establishing the book's early success, for mentoring the current authors, and for theirhard work in providing the foundations on which this edition builds

Ennius Bergsma deserves our special thanks Ennius initiated the development of

McKinsey's corporate-finance practice in the mid-1980s He inspired the original internalMcKinsey valuation handbook and mustered the support and sponsorship to turn thathandbook into a real book for an external audience

Tim and Marc are leaders of McKinsey's Corporate Performance Team, a group of

dedicated corporate-finance experts that influences our thinking every day A special

thank-you to Bernie Ferrari, who initiated the group and nurtured its development Theteam's leaders include Bing Cao, Susan Nolen Foushee, Abhishek Goel, Anuj Gupta, MimiJames, Mauricio Jaramillo, Bin Jiang, Mary Beth Joyce, David Kohn, Jean-Hugues

Monier, Siddharth Periwal, Rishi Raj, Werner Rehm, Abhishek Saxena, Ram Sekar,

Anurag Srivastava, and Zane Williams

We've made extensive use of McKinsey's Corporate Performance Analysis Tool (CPAT),which provides extensive data and the in-depth capital market analysis used in this book.Thank you to Bin Jiang, who developed and oversees CPAT, and to Bing Cao, Ritesh Jain,Saravanan Subramanian, and Angela Zhang, who prepared analyses for us Dick Foster, aformer McKinsey colleague and mentor, inspired the development of CPAT

Bill Javetski, our lead editor, ensured that our ideas were expressed clearly and concisely.Dennis Swinford edited and oversaw the production of more than 350 exhibits, ensuringthat they were carefully aligned with the text Karen Schenkenfelder provided carefulediting and feedback throughout the process We are indebted to her excellent eye fordetail

Michael Cichello, professor of finance at Georgetown University, expertly prepared many

of the teaching materials that accompany this book, including the end of chapter

problems and answers for the university edition and exam questions and answers Theseteaching materials are an essential supplement for professors and students using thisbook for finance courses

Concurrent with the fifth edition, McKinsey published a shorter book, entitled Value: The

Four Cornerstones of Corporate Finance, which explains the principles of value and their

implications for managers and investors without going into the technical detail of thishow-to guide We've greatly benefited from the ideas of that book's coauthors, RichardDobbs and Bill Huyett, as well as the lead editor, Neil DeCarlo

The intellectual origins of this book lie in the present-value method of capital budgetingand in the valuation approach developed by Professors Merton Miller and Franco

Modigliani (both Nobel laureates) in their 1961 Journal of Business article entitled

“Dividend Policy, Growth and the Valuation of Shares.” Others have gone far to

popularize their approach In particular, Professor Alfred Rappaport (Northwestern

University) and Joel Stern (Stern Stewart & Co.) were among the first to extend the

Miller-Modigliani enterprise valuation formula to real-world applications In addition tothese founders of the discipline, we would also like to acknowledge those who have

personally shaped our knowledge of valuation, corporate finance, and strategy For theirsupport and teachings, we thank Tony Bernardo, Dick Foster, Bob Holthausen, Rob

Kazanjian, Ofer Nemirovsky, Eduardo Schwartz, Chandan Sengupta, Jaap Spronk, JoelStern, Bennett Stewart, Sunil Wahal, and Ivo Welch

A number of colleagues worked closely with us on the sixth edition, providing supportthat was essential to its completion In Part One, “Foundations of Value,” Bill Javetskiand Dennis Swinford helped with the always-difficult task of writing the first chapter toposition the book properly Bin Jiang, Bing Cao, Ashaya Jain, Ritesh Jain, and Angela

Zhang provided most of the data analysis and insights, which involved crunching largeamounts of data In Part Three, “Advanced Valuation Techniques,” Stefan Roos and

Abhishek Saxena prepared the analysis for the Heineken case study In Part Four,

“Managing for Value,” Werner Rehm and Eileen Kelly Rinaudo contributed to the M&Achapter, André Annema cowrote the divestitures chapter, and Rob Palter and Werner

Rehm contributed to the investor communications chapter In Part Five, “Special

Situations,” André Annema contributed to the emerging-markets chapter, Zane Williams,Ashish Kumar Agarwal, and Bas Deelder contributed to the chapter on valuing banks, andMarco de Heer's dissertation formed the basis for the chapter on valuing cyclical

companies Angela Zhang provided the analysis for the chapter on valuing high-growthcompanies We thank them all for their insights and hard work

Of course, we could not have devoted the time and energy to this book without the

support and encouragement of McKinsey's strategy and corporate-finance practice

leadership, in particular Martin Hirt, Bill Huyett, Massimo Giordano, and Robert Uhlaner.Lucia Rahilly and Rik Kirkland ensured that we received superior editorial support fromMcKinsey's external publishing team

We would like to thank again all those who contributed to the first five editions We owe

a special debt to Dave Furer for help and late nights developing the original drafts of thisbook more than 25 years ago The first five editions and this edition drew upon work,ideas, and analyses from Carlos Abad, Paul Adam, Buford Alexander, Petri Allas,

Alexandre Amson, André Annema, the late Pat Anslinger, Vladimir Antikarov, Ali Asghar,Bill Barnett, Dan Bergman, Olivier Berlage, Peter Bisson, the late Joel Bleeke, Nidhi

Chadda, Carrie Chen, Steve Coley, Kevin Coyne, Johan Depraetere, Mikel Dodd, Lee

Dranikoff, Will Draper, Christian von Drathen, David Ernst, Bill Fallon, George Fenn,Susan Nolen Foushee, Russ Fradin, Gabriel Garcia, Richard Gerards, Alo Ghosh, IrinaGrigorenko, Fredrik Gustavsson, Marco de Heer, Keiko Honda, Alice Hu, Régis Huc, Mimi

James, Mauricio Jaramillo, Bin Jiang, Chris Jones, William Jones, Phil Keenan, Phil

Kholos, David Krieger, Shyanjaw Kuo, Michael Kuritzky, Bill Lewis, Kurt Losert, HarryMarkl, Yuri Maslov, Perry Moilinoff, Fabienne Moimaux, Jean-Hugues Monier, MikeMurray, Terence Nahar, Juan Ocampo, Martijn Olthof, Neha Patel, Vijen Patel, John

Patience, Bill Pursche, S R Rajan, Werner Rehm, Frank Richter, David Rothschild,

Michael Rudolf, Yasser Salem, Antoon Schneider, Ram Sekar, Meg Smoot, Silvia Stefini,Konrad Stiglbrunner, Ahmed Taha, Bill Trent, David Twiddy, Valerie Udale, Sandeep

Vaswani, Kim Vogel, Jon Weiner, Jack Welch, Gustavo Wigman, David Willensky, Marijn

de Wit, Pieter de Wit, Jonathan Witter, David Wright, and Yan Yang

For help in coordinating the flow of paper, e-mail, and phone calls, we owe our thanks toour assistants, Elizabeth Bruni Esposito and Laura Waters

We also extend thanks to the team at John Wiley & Sons, including Bill Falloon, MegFreeborn, Mary Daniello, and Vincent Nordhaus

Finally, thank you to Melissa Koller, Monique Donders, Kate Wessels, and our children:Katherine, Emily, and Juliana Koller; Maria, Julia, and Sarah Goedhart; and Jacob andAdin Wessels Our wives and families are our true inspirations This book would not havebeen possible without their encouragement, support, and sacrifice

Part One

Foundations of Value

1

Why Value Value?

The guiding principle of business value creation is a refreshingly simple construct:

companies that grow and earn a return on capital that exceeds their cost of capital createvalue Articulated as early as 1890 by Alfred Marshall,1 the concept has stood the test oftime Indeed, when managers, boards of directors, and investors have forgotten it, theconsequences have been disastrous The financial crisis of 2007–2008 and the Great

Recession that followed provide the most recent evidence of the point But a host of othercalamities, from the rise and fall of business conglomerates in the 1970s to the collapse ofJapan's economy in the 1990s to the Internet bubble, can all to some extent be traced to amisunderstanding or misapplication of this guiding principle

Today these accumulated crises have led many to call into question the foundations ofshareholder-oriented capitalism Confidence in business has tumbled.2 Politicians andcommentators push for more regulation and fundamental changes in corporate

governance Academics and even some business leaders have called for companies tochange their focus from increasing shareholder value to a broader focus on all

stakeholders, including customers, employees, suppliers, and local communities At theextremes, some have gone so far as to argue that companies should bear the

responsibility of promoting healthier eating and other social issues

Many of these impulses are naive There is no question that the complexity of managingthe coalescing and colliding interests of myriad owners and stakeholders in a moderncorporation demands that any reform discussion begin with a large dose of humility andtolerance for ambiguity in defining the purpose of business But we believe the currentdebate has muddied a fundamental truth: creating shareholder value is not the same asmaximizing short-term profits Companies that confuse the two often put both

shareholder value and stakeholder interests at risk Indeed, a system focused on creatingshareholder value isn't the problem; short-termism is Banks that confused the two at theend of the last decade precipitated a financial crisis that ultimately destroyed billions ofdollars of shareholder value, as did Enron and WorldCom at the turn of this century

Companies whose short-term focus leads to environmental disasters also destroy

shareholder value, not just directly through cleanup costs and fines, but via lingeringreputational damage The best managers don't skimp on safety, don't make value-

destroying decisions just because their peers are doing so, and don't use accounting orfinancial gimmicks to boost short-term profits, because ultimately such moves

undermine intrinsic value that is important to shareholders and stakeholders alike

What Does It Mean to Create Shareholder Value?

At this time of reflection on the virtues and vices of capitalism, we believe that it's criticalthat managers and boards of directors have a new, precise definition of shareholder value

creation to guide them, rather than having their focus blurred by a vague stakeholderagenda For today's value-minded executives, creating shareholder value cannot be

limited to simply maximizing today's share price for today's shareholders Rather, the

evidence points to a better objective: maximizing a company's collective value to current

and future shareholders, not just today's.

If investors knew as much about a company as its managers do, maximizing its currentshare price might be equivalent to maximizing value over time But in the real world,investors have only a company's published financial results and their own assessment ofthe quality and integrity of its management team For large companies, it's difficult evenfor insiders to know how financial results are generated Investors in most companiesdon't know what's really going on inside a company or what decisions managers are

making They can't know, for example, whether the company is improving its margins byfinding more efficient ways to work or by simply skimping on product development,

maintenance, or marketing

Since investors don't have complete information, it's easy for companies to pump up theirshare price in the short term For example, from 1997 to 2003, a global consumer

products company consistently generated annual growth in earnings per share (EPS)

between 11 percent and 16 percent Managers attributed the company's success to

improved efficiency Impressed, investors pushed the company's share price above those

of its peers—unaware that the company was shortchanging its investment in product

development and brand building to inflate short-term profits, even as revenue growthdeclined In 2003, managers had to admit what they'd done Not surprisingly, the

company went through a painful period of rebuilding Its stock price took years to

recover

This does not mean that the stock market is not “efficient” in the academic sense that itincorporates all public information Markets do a great job with public information, butmarkets are not omniscient Markets cannot price information they don't have Thinkabout the analogy of selling a house The seller may know that the boiler makes a weirdsound every once in a while or that some of the windows are a bit drafty Unless the sellerdiscloses those facts, it may be very difficult for a potential buyer to detect them, evenwith the help of a professional house inspector

Despite such challenges, the evidence makes it clear that companies with a long strategichorizon create more value The banks that had the insight and courage to forgo short-term profits during the last decade's real-estate bubble earned much better returns forshareholders over the longer term Over the long term, oil and gas companies known forinvesting in safety outperform those that skimp on such investment We've found,

empirically, that long-term revenue growth—particularly organic revenue growth—is themost important driver of shareholder returns for companies with high returns on capital.3We've also found that investments in research and development (R&D) correlate

powerfully with positive long-term total returns to shareholders (TRS), as graphed inExhibit 1.1.4

Creating value for both current and future shareholders means managers should not takeactions to increase today's share price if those actions will damage it down the road Someobvious examples include shortchanging product development, reducing product quality,

or skimping on safety Less obvious examples are making investments that don't take intoaccount likely future changes in regulation or consumer behavior (especially with regard

to environmental and health issues) Faced with volatile markets, rapid executive

turnover, and intense performance pressures, making long-term value-creating decisionscan take courage But it's management's and the board's task to demonstrate that courage,despite the short-term consequences, in the name of value creation for the collective

benefit of all present and future shareholders

Can Stakeholder Interests Be Reconciled?

Much recent criticism of shareholder-oriented capitalism has called on companies to

focus on a broader set of stakeholders beyond just its shareholders It's a view that haslong been influential in continental Europe, where it is frequently embedded in corporategovernance structures And we agree that for most companies anywhere in the world,pursuing the creation of long-term shareholder value requires satisfying other

stakeholders as well You can't create long-term value without happy customers,

suppliers, and employees

We would go even further We believe that companies dedicated to value creation arehealthier and more robust—and that investing for sustainable growth also builds stronger

economies, higher living standards, and more opportunities for individuals Our researchshows, for example, that many corporate social-responsibility initiatives also create

shareholder value, and that managers should seek out such opportunities.5 For example,IBM's free Web-based resources on business management not only help to build smalland midsize enterprises; they also improve IBM's reputation and relationships in newmarkets and develop relationships with potential customers

Similarly, Novo Nordisk's “triple bottom line” philosophy of social responsibility,

environmental soundness, and economic viability has led to programs to improve

diabetes care in China Novo Nordisk says such programs have burnished its brand, added

to its market share, and increased sales while improving physician education and patientoutcomes Or take Best Buy's efforts to reduce attrition among female employees BestBuy says the program has not only lowered turnover among women by more than 5

percent, but has also helped female employees create their own support networks andbuild leadership skills

But what should be done when a company's interests and those of its stakeholders aren'tcomplementary—for example, in areas such as employee compensation and benefits,

supplier management, and local community relationships? Most advocates of a

stakeholder-centric approach seem to argue that companies can maximize value for allstakeholders and shareholders simultaneously, without making trade-offs among them

For example, Cornell Law School professor Lynn Stout's book The Shareholder Value

Myth argues persuasively that nothing in U.S corporate law requires companies to focus

on shareholder value creation.6 But her argument that putting shareholders first harmsnearly everyone is really an argument against short-termism, not a prescription for how

to make trade-offs Similarly, R Edward Freeman, a professor at the University of

Virginia's Darden School of Business, has written at length proposing a stakeholder value

orientation In the recent book Managing for Stakeholders, he and his coauthors assert

that “there really is no inherent conflict between the interests of financiers and otherstakeholders.”7 John Mackey, founder and co-CEO of Whole Foods Market, recently co-

wrote Conscious Capitalism,8 in which he too asserts there are no trade-offs to be made.Such criticism is naive Strategic decisions often require myriad trade-offs among the

interests of different groups that are often at odds with each other And in the absence ofother principled guidelines for such decisions, when there are trade-offs to be made,

prioritizing long-term value creation is best for the allocation of resources and the health

of the economy

Consider employee stakeholders A company that tries to boost profits by providing a

shabby work environment, underpaying employees, or skimping on benefits will havetrouble attracting and retaining high-quality employees Lower-quality employees canmean lower-quality products, reduced demand, and damage to the brand reputation Moreinjury and illness can invite regulatory scrutiny and more union pressure More turnoverwill inevitably increase training costs With today's more mobile and more educated

workforce, such a company would struggle in the long term against competitors offering

more attractive environments If the company earns more than its cost of capital, it mightafford to pay above-market wages and still prosper, and treating employees well can begood business But how well is well enough? The stakeholder approach, defined as

running the company in a way that treats all stakeholder interests equally, doesn't provide

an answer A shareholder focus does: pay wages that are just enough to attract qualityemployees and keep them happy and productive, pairing those wages with a range of

nonmonetary benefits and rewards Even companies that have shifted production of

products like clothing and textiles to low-cost countries with weak labor protection havefound that they need to monitor the working conditions of their suppliers or face a

consumer backlash

Or consider how high a price a company should charge for its products A shareholderfocus would weigh price, volume, and customer satisfaction to determine a price that

creates the most shareholder value However, that price would also have to entice

consumers to buy the products—not just once, but multiple times, for different

generations of products A company might still thrive if it charged lower prices, but

there's no way to determine whether the value of a lower price is greater for consumersthan the value of a higher price to its shareholders

Consider whether companies in mature, competitive industries should keep open cost plants that lose money, just to keep employees working and prevent suppliers fromgoing bankrupt To do so in a globalizing industry would distort the allocation of

high-resources in the economy, notwithstanding the significant short-term local costs

associated with plant closures.9

Energy companies have particularly difficult decisions to make Government energy

policy typically toggles between the goals of cost, energy security, and environmental

impact These do not easily line up in a way that makes for smooth integration into

energy companies' investment decisions In practice, the companies need to make careful,balanced judgments around the trade-offs embedded in government policy actions in

order to factor them into long-term value-creation strategies And the greater the policyuncertainty, the harder it is for companies to create long-term value in a way that is goodfor efficient resource allocation and the health of the economy

Managers may agonize over decisions that have such a pronounced impact on workers'lives But consumers benefit when goods are produced at the lowest possible cost, and theeconomy benefits when unproductive plants are closed and employees move to new jobswith more competitive companies And while it's true that employees often can't just pick

up and relocate, it's also true that value-creating companies create more jobs When

examining employment, we found that the U.S and European companies that created themost shareholder value in the past 10 years have shown stronger employment growth(see Exhibit 1.2).10

Shareholder Capitalism Cannot Solve All Social Issues

There are some trade-offs that company managers can't make and that neither a

shareholder nor a stakeholder approach to governance can help This is especially truewhen it comes to issues affecting people who aren't immediately involved with the

company, as may be the case with investors, customers, and suppliers These so-calledexternalities—for example, a company's carbon emissions affecting parties that have nodirect contact with the company—are often beyond the ken of corporate decision makingbecause there is no objective basis for making trade-offs among parties

Consider how this applies to climate change, potentially one of the largest social issuesfacing the world One natural place to look for a solution is to reduce coal production used

to make electricity, among the largest human-made sources of carbon emissions.11 Buthow are the managers of a coal-mining company to make all the trade-offs needed to

begin solving our environmental problems? If a long-term shareholder focus led them toanticipate potential regulatory changes, they would modify their investment strategiesaccordingly—they might not want to open new mines, for example But if the companyabruptly stopped operating existing ones, not only would the company's shareholders losetheir entire investment, but so would its bondholders, which are often pension funds All

of the company's employees would be out of work, with magnifying effects on the entirelocal community Second-order effects would be unpredictable Without concerted action

among all coal producers, another supplier could step up to meet demand Even with

concerted action, power plants might be unable to produce electricity—idling their

workers and causing electricity shortages that undermine the economy What objectivecriteria would any individual company use to weigh the economic and environmentaltrade-offs of such decisions—whether they're privileging shareholders or stakeholders?For their part, longer-term investors, themselves concerned with environmental issuessuch as carbon emissions, water scarcity, and land degradation, are connecting value andlong-term sustainability In 2014, heirs to the Rockefeller Standard Oil fortune decided tojoin Stanford University's board of trustees in avoiding shares in coal companies Long-term-oriented companies must be attuned to long-term changes that will be demanded byboth investors and governments, so they can adjust their strategies over a 5-, 10-, or 20-year time horizon and reduce the risk of stranded assets, or those that are still productivebut not in use because of environmental or other issues

For any company, the complexity of addressing universal social issues like climate changeposes an unresolved question: if the task does not fall to the individual company, then towhom does it fall? Some might argue that it would be better for the government to

develop incentives, regulations, and taxes In the example of climate change, this viewmight favor government action to encourage a migration away from polluting sources ofenergy Others may espouse a free-market approach, allowing creative destruction to

replace aging technologies and systems with cleaner and more efficient sources of power.This trading off of different economic interests and time horizons is precisely what

governments are supposed to do, with institutional investors such as pension funds in acritical supporting role At times, the failure of governments and long-term investors tostep up and play their roles effectively can be what leads to the largest divergence

between shareholder value creation and the impact of externalities Failure to price orcontrol for externalities will lead to a misallocation of resources

Shareholder capitalism has taken its lumps in recent years, no question Yet we see in ourwork that the shareholder model, thoughtfully embraced as a collective approach to

present and future value creation, is the best one at bridging the broad and varied

interests of shareholders and stakeholders alike

Consequences of Forgetting Value-Creation Principles

When companies forget the simple value-creation principles, the negative consequences

to the economy can be huge Two recent examples of many executives failing in their duty

to focus on true value creation are the Internet bubble and the financial crisis of 2008.During the Internet bubble, managers and investors lost sight of what drove return oninvested capital (ROIC); indeed, many forgot the importance of this ratio entirely Manyexecutives and investors either forgot or threw out fundamental rules of economics in therarefied air of the Internet revolution The notion of “winner take all” led companies andinvestors to believe naively that all that mattered was getting big fast, and that they could

worry about creating an effective business model later Increasing-returns logic was alsomistakenly applied to online pet supplies and grocery delivery services, even though thesefirms had to invest (unsustainably, eventually) in more drivers, trucks, warehouses, andinventory when their customer base grew When the laws of economics prevailed, as theyalways do, it was clear that many Internet businesses did not have the unassailable

competitive advantages required to earn even modest returns on invested capital TheInternet has revolutionized the economy, as have other innovations, but it did not andcould not render obsolete the rules of economics, competition, and value creation

Similarly, behind the more recent financial and economic crises beginning in 2008 liesthe fact that banks and investors forgot the principles of value creation Banks lent money

to individuals and speculators at low teaser rates on the assumption that house priceswould only increase Banks packaged these high-risk debts into long-term securities andsold them to investors who used short-term debt to finance the purchase, thus creating along-term risk for whoever lent them the money When the home buyers could no longerafford the payments, the real estate market crashed, pushing the values of many homesbelow the values of loans taken out to buy them At that point, homeowners could neithermake the required payments nor sell their houses Seeing this, the banks that had issuedshort-term loans to investors in securities backed by mortgages became unwilling to rollover those loans, prompting the investors to sell all such securities at once The value ofthe securities plummeted Finally, many of the large banks themselves owned these

securities, which they, of course, had also financed with short-term debt they could nolonger roll over

In the past 30 years, the world has seen at least six financial crises that arose largely

because companies and banks were financing illiquid assets with short-term debt: theU.S savings and loan catastrophe in the 1980s, the East Asian debt crisis in the mid-

1990s, the Russian government default in 1998, the collapse in that same year of the U.S.hedge fund Long-Term Capital Management, the U.S commercial real estate crisis in theearly 1990s, and the Japanese financial crisis that began in 1990 and, according to some,continues to this day

Short-Termism Runs Deep

One of the causes of these economic calamities is the short-termism of many companies.What is most relevant about Stout's argument and that of others is its implicit criticism ofshort-termism It is a fair critique of today's capitalism Despite overwhelming evidencelinking intrinsic investor preferences to long-term value creation,12 too many managerscontinue to plan and execute strategy—and then report their performance—against

shorter-term measures, particularly earnings per share (EPS)

As a result of their focus on short-term EPS, major companies often pass up

value-creating opportunities In a survey of 400 chief financial officers, two Duke Universityprofessors found that fully 80 percent of the CFOs said they would reduce discretionary

spending on potentially value-creating activities such as marketing and R&D in order tomeet their short-term earnings targets.13 In addition, 39 percent said they would give

discounts to customers to make purchases this quarter rather than next, in order to hitquarterly EPS targets Such biases shortchange all stakeholders

As an illustration of how executives get caught up in a short-term EPS focus, consider ourexperience with companies analyzing a prospective acquisition The most frequent

question managers ask is whether the transaction will dilute EPS over the first year ortwo Given the popularity of EPS as a yardstick for company decisions, you might thinkthat a predicted improvement in EPS would be an important indication of an acquisition'spotential to create value However, there is no empirical evidence linking increased EPSwith the value created by a transaction.14 Deals that strengthen EPS and deals that diluteEPS are equally likely to create or destroy value

If such fallacies have no impact on value, why do they prevail? The impetus for a termism varies Some executives argue that investors won't let them focus on the longterm; others fault the rise of shareholder activists in particular Yet our research showsthat even if short-term investors cause day-to-day fluctuations in a company's share priceand dominate quarterly earnings calls, longer-term investors are the ones who align

short-market prices with intrinsic value.15 Moreover, the evidence shows that, on average,

activist investors strengthen the long-term health of the companies they pursue—for

example, often challenging existing compensation structures that encourage

short-termism.16 Instead, we often find that executives themselves or their boards are usuallythe source of short-termism In a 2013 survey of more than 1,000 executives and boardmembers, most cited their own executive teams and boards (rather than investors,

analysts, and others outside the company) as the greatest sources of pressure for term performance.17

short-The results can defy logic At a company pursuing a major acquisition, we participated in adiscussion about whether the deal's likely earnings dilution was important One of thecompany's bankers opined that he knew any impact on EPS would be irrelevant to value,but he used it as a simple way to communicate with boards of directors Elsewhere, we'veheard company executives acknowledge that they, too, doubt that the impact on EPS is soimportant—but they also use it anyway, “for the benefit of Wall Street analysts.” Investorsalso tell us that a deal's short-term impact on EPS is not that important Apparently

everyone knows that a transaction's short-term impact on EPS doesn't matter, yet they allpay attention to it

The pressure to show strong short-term results often mounts when businesses start tomature and see their growth begin to moderate Investors go on baying for high growth.Managers are tempted to find ways to keep profits rising in the short term while they try

to stimulate longer-term growth However, any short-term efforts to massage earningsthat undercut productive investment make achieving long-term growth even more

difficult, spawning a vicious circle

Some analysts and some short-term-oriented investors will always clamor for short-termresults However, even though a company bent on growing long-term value will not beable to meet their demands all of the time, this continuous pressure has the virtue of

keeping managers on their toes Sorting out the trade-offs between short-term earningsand long-term value creation is part of a manager's job, just as having the courage to

make the right call is a critical personal quality Perhaps even more important, it is up tocorporate boards to investigate and understand the economics of the businesses in theirportfolio well enough to judge when managers are making the right trade-offs and, aboveall, to protect managers when they choose to build long-term value at the expense of

exchange-listed companies and companies owned by private-equity firms, 15 of 20

respondents said that private-equity boards clearly added more value Their answers

suggested two key differences First, listed-company directors are more focused on riskavoidance than value creation Second, private-equity directors spend on average nearlythree times as many days on their roles as do those at listed companies.18 Changes in CEOevaluation and compensation might also help The compensation of most CEOs and

senior executives is still skewed to short-term accounting profits, often by formula Giventhe complexity of managing a large multinational company, we find it odd that so muchweight is given to a single number

of claims to cash flows, and accounting techniques that may change the timing of profitswithout actually changing cash flows

This guiding principle of value creation links directly to competitive advantage, the coreconcept of business strategy Only if companies have a well-defined competitive

advantage can they sustain strong growth and high returns on invested capital To thecore principles, we add the empirical observation that creating sustainable value is a long-term endeavor, one that needs to take into account wider social, environmental,

technological, and regulatory trends

Competition tends to erode competitive advantages and, with them, returns on investedcapital Therefore, companies must continually seek and exploit new sources of

competitive advantage if they are to create long-term value To that end, managers mustresist short-term pressure to take actions that create illusory value quickly at the expense

of the real thing in the long term Creating value for shareholders is not the same as, forexample, meeting the analysts' consensus earnings forecast for the next quarter Nor is itignoring the effects of decisions made today that may create greater costs down the road,from environmental cleanup to retrofitting plants to meet future pollution regulations Itmeans balancing near-term financial performance against what it takes to develop a

healthy company that can create value for decades ahead—a demanding challenge

This book explains both the economics of value creation (for instance, how competitiveadvantage enables some companies to earn higher returns on invested capital than

others) and the process of measuring value (for example, how to calculate return on

invested capital from a company's accounting statements) With this knowledge,

companies can make wiser strategic and operating decisions, such as what businesses toown and how to make trade-offs between growth and return on invested capital Equally,this knowledge will enable investors to calculate the risks and returns of their

investments with greater confidence

Applying the principles of value creation sometimes means going against the crowd Itmeans accepting that there are no free lunches It means relying on data, thoughtful

analysis, and a deep understanding of the competitive dynamics of your industry Wehope this book provides readers with the knowledge to help them make and defend

decisions that will create value for investors and for society at large throughout their

careers

Review Questions

1 What benefits does a long-term perspective on value creation offer for companies? Forthe economy?

2 Why is maximizing current share price not equivalent to maximizing long-term value?

3 When managers and boards of directors evaluate firm performance, how might

focusing exclusively on corporate earnings lead them astray?

4 Give examples of situations where shareholders' and other stakeholders' interests arecomplementary Give examples of situations where these interests are not

complementary If interests conflict, what should management do?

5 What are some of the common features of the 2008 stock market crash and previousmarket crashes—for example, Japan's in the 1990s or the Internet bubble around theturn of the millennium?

6 If growth is a significant value driver, does getting bigger translate into creating value?Explain

7 What more could boards of directors and shareholders do to ensure that managerspursue long-term value creation?

1 Alfred Marshall, Principles of Economics (New York: Macmillan, 1890), 1:142

2 An annual Gallup poll in the United States showed that the percentage of respondentswith little or no confidence in big business increased from 27 percent in the 1983–1986period to 38 percent in the 2011–2014 period For more, see Gallup, “Confidence inInstitutions,” www.gallup.com

3 B Jiang and T Koller, “How to Choose between Growth and ROIC,” McKinsey on

Finance, no 25 (Autumn 2007), 19–22, www.mckinsey.com However, we didn't findthe same relationship for companies with low returns on capital

4 We've performed the same analyses for 15 and 20 years and with different start and enddates and always found similar results

5 S Bonini, T Koller, and P H Mirvis, “Valuing Social Responsibility Programs,”

McKinsey Quarterly (July 2009), www.mckinsey.com

6 L Stout, The Shareholder Value Myth: How Putting Shareholders First Harms

Investors, Corporations, and the Public (Oakland, CA: Berrett-Koehler, 2012).

7 R E Freeman, J S Harrison, and A C Wicks, Managing for Stakeholders: Survival,

Reputation, and Success (New Haven, CT: Yale University Press, 2007), 5.

8 J Mackey and R Sisodia, Conscious Capitalism: Liberating the Heroic Spirit of

Business (Boston: Harvard Business School Publishing, 2013).

9 Some argue that well-functioning markets also need well-functioning governments toprovide the safety nets and retraining support to make essential restructuring

processes more equitable

10 We've performed the same analyses for 15 and 20 years and with different start andend dates and always found similar results

11 In 2011, coal accounted for 44 percent of the global CO2 emissions from energy

production International Energy Agency, CO 2 Emissions from Fuel Combustion, 2013

ed., www.iea.org

12 R N Palter, W Rehm, and J Shih, “Communicating with the Right Investors,”

McKinsey Quarterly (April 2008), www.mckinsey.com

13 J R Graham, C R Harvey, and S Rajgopal, “Value Destruction and Financial

Reporting Decisions,” Financial Analysts Journal 62, no 6 (2006): 27–39.

14 R Dobbs, B Nand, and W Rehm, “Merger Valuation: Time to Jettison EPS,” McKinsey

Quarterly (March 2005), www.mckinsey.com

15 Palter, Rehm, and Shih, “Communicating with the Right Investors.”

16 J Cyriac, R De Backer, and J Sanders, “Preparing for Bigger, Bolder Shareholder

Activists,” McKinsey on Finance (March 2014), www.mckinsey.com.

17 Commissioned by McKinsey & Company and by the Canada Pension Plan InvestmentBoard, the online survey, “Looking toward the Long Term,” was in the field from April

30 to May 10, 2013, and garnered responses from 1,038 executives representing thefull range of industries and company sizes globally Of these respondents, 722

identified themselves as C-level executives and answered questions in the context ofthat role, and 316 identified themselves as board directors and answered accordingly

To adjust for differences in response rates, the data are weighted by the contribution ofeach respondent's nation to global gross domestic product (GDP) For more, see

“Focusing Capital on the Long Term,” www.fclt.org

18 V Acharya, C Kehoe, and M Reyner, “The Voice of Experience: Public versus Private

Equity,” McKinsey on Finance (Spring 2009): 16–21.

2

Fundamental Principles of Value Creation

Companies create value for their owners by investing cash now to generate more cash inthe future The amount of value they create is the difference between cash inflows andthe cost of the investments made, adjusted to reflect the fact that tomorrow's cash flowsare worth less than today's because of the time value of money and the riskiness of futurecash flows As we will demonstrate, a company's return on invested capital (ROIC)1 andits revenue growth together determine how revenues are converted to cash flows (andearnings) That means the amount of value a company creates is governed ultimately byits ROIC, revenue growth, and ability to sustain both over time Keep in mind one

important caveat: a company will create value only if its ROIC is greater than its cost ofcapital (the opportunity cost for its investors) Moreover, only if ROIC exceeds cost ofcapital will growth increase a company's value Growth at lower returns actually reduces acompany's value Exhibit 2.1 illustrates this core principle of value creation.2

Following these principles helps managers decide which investments will create the mostvalue for shareholders in the long term The principles also help investors assess the

potential value of companies they might consider investing in This chapter explains therelationships that tie together growth, ROIC, cash flows, and value, and it introduces theway managers can use these relationships to decide among different investments or

strategies For example, we will show that high-ROIC companies typically create morevalue by focusing on growth, while lower-ROIC companies create more value by

increasing ROIC

One might expect universal agreement on a notion as fundamental as value, but this isn'tthe case: many executives, boards, and financial media still treat accounting earnings andvalue 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 wholestory of value creation, and focusing too much on earnings or earnings growth often leadscompanies to stray from a value-creating path

For example, earnings growth alone can't explain why investors in drugstore chain

Walgreen Co., with sales of $72 billion in 2012, and consumer products company GeneralMills, with sales of $18 billion the same year, earned similar shareholder returns between

1985 and 2012.3 These two successful companies had very different growth rates Duringthe period, after-tax operating profits for Walgreens grew 13 percent per year, while those

of General Mills grew 9 percent annually This means that profits for Walgreens in 2012were 25 times larger than in 1985, while profits at General Mills were only 9 times larger.Even though Walgreens was one of the fastest-growing companies in the United Statesduring this time, its average annual shareholder returns were 10 percent, about the same

as for the significantly slower-growing General Mills The reason General Mills couldcreate the same value as Walgreens, despite 30 percent slower growth, was that GeneralMills earned a 29 percent ROIC, while the ROIC for Walgreens was 16 percent (a goodrate for a retailer)

To be fair, if all companies in an industry earned the same ROIC, then earnings growth

would be the differentiating metric For reasons of simplicity, analysts and academics

have sometimes made this assumption, but as Chapter 6 demonstrates, returns on

invested capital can vary considerably, not only across industries but also between

companies within the same industry

The Relationship of Growth, ROIC, and Cash Flow

Disaggregating cash flow into revenue growth and ROIC helps illuminate the underlyingdrivers of a company's performance Say a company's cash flow was $100 last year andwill be $150 next year This doesn't tell us much about its economic performance, sincethe $50 increase in cash flow could come from many sources, including revenue growth, areduction in capital spending, or a reduction in marketing expenditures But if we told youthat the company was generating revenue growth of 7 percent per year and would earn areturn 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 topeers, its cost of capital, and its own historical performance

Growth, ROIC, and cash flow are mathematically linked To see how, consider two

companies, Value Inc and Volume Inc., whose projected earnings, investment, and

resulting cash flows are displayed in Exhibit 2.2 Both companies earned $100 million inyear 1 and increased their revenues and earnings at 5 percent per year, so their projectedearnings 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 illustrateshow 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 lowerinvestment rate results in 50 percent higher cash flows than at Volume Inc while

generating the same level of profits

We can value the two companies by discounting their future cash flows at a discount ratethat reflects what investors expect to earn from investing in the companies—that is, theircost of capital For both companies, we discounted 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 allfuture cash flows: $1,500 million for Value Inc (shown in Exhibit 2.3) and $1,000 millionfor 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.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 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).4 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 togethermathematically in the following relationship:

Applying the formula to Value Inc.:

Applying it to Volume Inc.:

As you can see, Volume Inc needs a higher investment rate to achieve the same growth.Another way to look at this comparison is in terms of cash flow:

where

So:

For Value Inc.:

For Volume Inc.:

Since the three variables are tied together mathematically, you can describe a company'sperformance with any two variables We generally describe a company's performance interms of growth and ROIC because, as mentioned earlier, you can analyze growth andROIC across time and versus peers

Note that near-term cash flow itself may not be a meaningful performance indicator.Consider what would happen if Value Inc were to find more investment opportunities at

a 25 percent ROIC and be able to increase its growth to 8 percent per year Exhibit 2.4shows the projected earnings and cash flow Because it would be growing faster, Value

Inc would need to invest more of its earnings each year, so its cash flow at 8 percent

growth would be lower than at 5 percent growth until year 9 However, its value at

8 percent growth would double, to $3,000 million, because its cash flows are higher inthe long term

Balancing ROIC and Growth to Create Value

Exhibit 2.5 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 theassumptions of growth and ROIC, discounted at the company's cost of capital—in thiscase, assuming a 9 percent cost of capital and a company that earns $100 in the first

year.5