Table of contents
2 Explanation of ROIC, revenue growth and TRS
3 Discussion of the research question
In this paper, the key variables of company valuation, return on invested capital (ROIC) and revenue growth, are connected to the total returns to shareholders (TRS). It will be examined whether a firm with higher ROIC and revenue growth numbers could lead to a lower TRS. For a better understanding of this specific field of practice, there will first be a brief explanation of the relevant terms in the next chapter.
2 Explanation of ROIC, revenue growth and TRS
The value of a company depends mainly on its key drivers, ROIC and revenue growth, both considered over a long-term time horizon. Growth is only valuable in this context if ROIC is higher than the company’s cost of capital, otherwise value will be destroyed (Koller et al. 2015).
ROIC is described as “the most important driver of shareholder value” (Guske 2016). It is defined as after-tax operating profit (NOPLAT) divided by invested capital, which is the sum of the working capital and the fixed assets (Koller et al. 2015). Thus, ROIC shows how successful a company is using its assets to create returns. All else equal, a higher ROIC is always better in a valuation context (Ibid.). From a shareholder’s perspective, this metric has to be compared with the individual weighted average cost of capital (WACC) in order to evaluate the effective usage of the invested capital. The result is the economic profitability which differs clearly from the commonly used accounting profitability (Patterson 2017). The latter one is much easier to compute but it is not showing the true economic situation of a business, as it can be easily manipulated by managers. On top of that, there are lots of adjustments necessary to arrive from the accounting data at ROIC. Operating profit and invested capital can only be computed after analyzing hundreds of pages of financial statement filings (Trainer 2016). Another way of looking at ROIC is to use a per unit calculation:
This formula breaks down NOPLAT into price and cost and therefore implies that a company which can charge a higher price premium, has lower production costs or has to invest lower capital per unit exhibits a higher ROIC which is driven by a competitive advantage. Hence, industries with scalable returns like software can earn higher ROICs than commodity-dependent industries like utilities. Furthermore, there is evidence that if a company is finding a strategy to deliver a high ROIC, it is likely to sustain it over time (Koller et al. 2015).
Revenue growth, as the second value driver, can be divided into three components: At first, we have portfolio momentum, which is based on overall market expansion leading to an organic revenue growth of the distinctive market segments. The second one is market share performance which measures organic growth resulting from the expansion of a firm’s market share in a specific segment. Lastly, the third driver of revenue growth is mergers and acquisitions (M&A) describing the inorganic revenue growth which is bought or sold externally (Ibid.).
It is important to note, that not all of these growth drivers are creating value equally. Growth comes always at the expense of another market participant. The scope of the value added depends on the retaliation rate of the losers. If, for example, market share is won from an established competitor, he can retaliate and take the customer back. Furthermore, simple price increases can be answered by a reduced customer consumption, leading both to lower long-term value. If on the other hand growth is driven by the creation of a new market through a completely new product, then there are no established rivals and the revenue is taken from distant companies, which are often not able to retaliate. This will be the most valuable option, followed by attracting new customers and convincing existing customers to expand their buying (Ibid.).
A successful management technique to cope with all those different growth drivers is to conduct a granular approach by dividing the company into hundreds of cells, evolving from the different business lines and regions a firm is operating. For every single cell there has to be a distinct screening as well as an investment or divestment decision concerning growth potential, depending on the following questions: “How likely is each cell to win in the market? Do resources need to be reallocated? Is it time to exit a market altogether?” (Baghai et al. 2009)
Sustaining high revenue growth rates over a long-term horizon is extremely challenging. It is only possible by consistently finding new product markets and entering them during the time of the highest growth of their product life cycle. To increase growth rates while the company is already getting bigger in terms of total sales, it is necessary to find new products delivering even more growth. This is called the portfolio treadmill effect (Koller et al. 2015).
The metric TRS is defined as the sum of the stock price appreciation and the sum of dividends paid to the shareholders over a given period, divided by the beginning share price (Kay 1998). Furthermore, the market value of any shares received in a spin-off and the relating dividends, as well as the value of any warrants issued on any of the stocks should be regarded (Kennon 2016). The idea behind that is the aligning of shareholders and managers interest by connecting performance bonuses to TRS. In reality, the aligning does only work over long periods, e.g. at a minimum 10-15 years. This is reasoned by two factors: Firstly, short-term TRS depends heavily on the company’s position in the business cycle. In a mature business environment, shareholders are normally expecting a further improvement of performance, even if the preceding years have already been very positive. That leads again to the treadmill effect as expectations are growing exponentially. Secondly, the just mentioned traditional method to compute TRS does not reflect the real operating improvements as a result of senior management activity. The pure focus on dividends and the change in share price can lead to a short-term thinking at the expense of long-term value creation (Koller et al. 2015). Basically, TRS is driven by the change in economic profit, the above described performance measurement metric (Hausmann et al. 2015).
3 Discussion of the research question
Generally, there should be a strong positive relationship between companies with high ROIC and revenue growth and their stock market performance, expressed by the previous explained traditional metric TRS, as value creation should be aligned with rising equity valuations leading to higher shareholder returns. “Greater focus on ROIC and other economic value metrics can help align managers with the long-term interest of investors and build stronger company foundations”. (Patterson 2017) Of course, this is only true, if ROIC is higher than the WACC, as presented in chapter 1. Concerning valuation multiples, it can be stated that a higher ROIC means that there is higher cash flow at the same earnings, which leads to a higher earnings multiple. And if multiples are expanded, shareholder value in terms of TRS is enlarged. Next to that, long-term organic revenue growth is the most important driver of stockholder returns for companies with high returns on capital, i.e. growth is also positively affecting multiples (Koller et al. 2015). Thus, on first sight, the research hypothesis stating that there could be lower TRS in a higher ROIC and growth environment, all else equal, could be clearly rejected.
However, there are other circumstances imaginable, where TRS could be decreasing even if ROIC and growth are on a high level. It is important to recognize, that profits, ROIC and revenue growth are all backward looking, and are giving no reliable indicator for future short-term value improvement. If an exemplary company is increasing ROIC and revenue growth by raising prices while cutting advertising budgets, it is very likely that competitors can take market shares in the next period. The necessary reaction would be a dramatic shift in strategy, lowering prices to win back customers. This process could last many years and would in turn lead to lower TRS as shareholders expectations are not met and returns as well as growth numbers are shrinking (Koller et al. 2010). Thus, it is important to define the exact time frame, i.e. forward or backward looking and short- or long term, when comparing TRS with ROIC and growth. On top of that, company executives should decompose even positive return metrics to understand why the numbers are this extraordinarily high.
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- University of London – CeFiMS