I’m currently reading through the book “Valuation: Measuring and Managing the Value of Companies by McKinsey & Company”. The following will be my notes and reflections / learning following each chapter of the book. As this is my first time reading the book, I might not fully understand the concepts and may miss out on some key points. However, I intend to revisit this book multiple times in the future and update the page accordingly. This will be purely for my own learning and journalling purposes, but it’ll be nice if it helps someone else out there as well.
The conversion of revenues into cash flows — and earnings — is a function of a company’s return on invested capital and its revenue growth.
High ROIC companies typically create more value by focusing on growth, while lower-ROIC companies create more value by increasing ROIC.
Anything that does not increase cash flows does not increase the value of the company.
Since accounting earnings may not always translate into cash flows, focusing too much on accounting earnings growth will cause a company to stray from value creation.
Free cash flow is the cash leftover for investors once investments have been subtracted from operating cash flows.
Note: Earnings are used synonymously with NOPAT (Net Operating Profit After Tax) in this book.
As growth slows at any level of ROIC, the cash generated per dollar of NOPAT increases. Taking ROIC constant, this means that the investment rate decreases as growth slows, so more cash is available for distribution to shareholders.
This explains why companies with high ROIC but slowing growth can pay out much larger amounts of their earnings to investors. This is what we want to maximise in a company — the amount of cash available for distribution once it has maximised its growth potential and starts returning cash to shareholders.
Improving ROIC for any level of growth always increases value because it reduces the investment required for growth. i.e. less capital needs to be reinvested to obtain the same growth rate.
“Don’t fall for the trap that growth will lead to scale economies that automatically increase a company’s return on capital. It almost never happens for mature businesses.”
You want to own a company that can grow at the same rate as its competitors with relatively little capital investment. This means you want a company with a relatively high ROIC. This translates to more cash available for distribution to shareholders, and assuming the high ROIC can be maintained or improved as the reinvestment rate increases, the company can grow at a faster rate than its competitors.
In general, companies already earnings a high ROIC can generate more additional value by increasing their rate of growth, rather than their ROIC. For their part, low-ROIC companies will generate relatively more value by focusing on increasing their ROIC.
Important to consider return on incremental invested capital (ROIIC) as the ROIC of incremental investments may decrease as the company grows. This is because the company may have to invest in less attractive projects as it grows, which may decrease the overall ROIC of the company. “Different types of growth earn different returns on capital, so not all growth is equally value creating.” But it’s fine to grow as long as the ROIIC remains above the WACC.
Growth strategies based on organic new-product development frequently have the highest returns because they don’t require much new capital. What’s more, the investments to create new products are not required all at once, so the downside risk is limited. On the contrary, acquisitions require large amounts of capital upfront and are often riskier in terms of the amount of value it’ll create (although one could argue that acquisitions bring along it’s own revenue earnings which can pad the downside risk).
Only strive for growth if ROIC > WACC.
Value creation is strongly correlated to total shareholder return (TSR). TSR is the sum of the change in stock price and dividends paid to shareholders.
Even if ROIC declines over time, as long as it’s above WACC, value is created. Do not be afraid to push for growth at the expense of ROIC, so long as ROIC remains above WACC. This helps maximise the value created by the company.
Small startups could possibly increase ROIC over time by pushing for growth. (Think Grab, providing huge initial discounts that likely generate short term ROIC < WACC, but as they scale and increase their ROIC, they gain more market share, develop their brand value, and ROIC improves over time.) This is not likely the same with mature companies.
Rule: Low ROIC companies should prioritise increasing ROIC over growth. High ROIC companies should prioritise growth over increasing ROIC.
The method to increase ROIC matters too. We can either improve the operating margin or the capital productivity (i.e., using less working capital). For low ROIC, margin improvement provides a slight advantage relative to capital productivity in terms of value creation. For high ROIC, margin improvement provides a substantial advantage relative to capital productivity for increasing value.
Share dilution leads to reduced cash flows per shareholder. This happens often due to outsized compensation packages for management without a proportionate share-buyback program.
“In every circumstance, executives should focus on increasing cash flows rather than finding gimmicks that merely reditribute value among investors or make reported results look better. … If you can’t pinpoint the tangible source of value creation, you’re probably looking at an illusion …”
Share buybacks are value destroying if the returns on the buybacks are less than the WACC or less than the alternative opportunities. This is because the company is essentially buying back shares at a price higher than the intrinsic value of the company. This is why it’s important to have a disciplined approach to share buybacks. A company should never buyback shares just to support the stock price and boost earnings per share. It should only do so if the shares are undervalued. Treat share buybacks as if another investment opportunity.
A company borrowing money to buy back shares will likely lead to a lower increase in earnings relative to the percentage of shares bought back due to the cost of borrowing.
“Share repurchases increase EPS immediately, but possibly at the expense of lower long-term earnings.”
Acquisitions create value only when the combined cash flows of the two companies increase (prevAcquirerCF + prevAcquiredCF < combinedCompaniesCF) due to cost reductions, accelerated revenue growth (i.e., due to synergies and cross-selling), or better use of fixed and working capital (i.e., share inventory, economies of scale).
Be wary of financial engineering (defined in the book as “the use of financial instruments or structures other than straight debt and equity to manage a company’s capital structure and risk profile) as it’s often a way to make financial statements pretty without underlying substance. Always go back to projecting future cash flows.
A mature company is expected to have high ROICs. If a mature company has low ROICs, this implies that the company likely has a flawed business model or unattractive industry structure.
Definitions:
Net operating profit after taxes (NOPAT): Profits generated from the company’s core operations after subtracting the income taxes related to those core operations.
Invested capital: Cumulative amount the business has invested in its core operations—primarily property, plant, and equipment and working capital.
Net investment: The increase in invested capital from one year to the next.
Net Investment = Invested Capital at t+1 - Invested Capital at t
Free cash flow (FCF): Cash flow generated by the core operations of the business after deducting investments in new capital.
FCF = NOPAT - Net Investment
FCF = NOPAT * (1 - Investment Rate) # alternative formula
FCF = NOPAT * (1 - Growth / ROIC) # alternative formula
Return on invested capital (ROIC): Return the company earns on each dollar invested in the business.
ROIC = NOPAT / Invested Capital
Investment Rate (IR): The portion of NOPAT invested back into the business.
IR = Net Investment / NOPAT
IR = Growth / ROIC # if we assume a constant ROIC and growth rate
Weighted average cost of capital (WACC): The rate of return that investors expect to earn from investing in the company and therefore the appropriate discount rate for the free cash flow.
Growth (g): Is the rate at which the company’s NOPAT and cash flow grow each year.
Mathematical Formulas:
Assuming a constant ROIC and growth rate:
Value per dollar of Invested Capital = ROIC * [(1 - Growth / ROIC) / (WACC - Growth)] # Valuation multiple that we can use to compare across companies. The higher the better. Good alternative to standard earnings multiple like the P/E ratio.
Value per dollar of Invested Capital = ROIC * [(1 - Growth / ROIIC) / (WACC - Growth)] # Use this instead of the above if ROIIC != ROIC.
Value = Year 1 NOPAT * (1 - Growth / ROIC) / (WACC - Growth) # DCF formula. Useful to see what generates value. Derived from everything else. Rarely used due to assumption of constant growth rate and ROIC.
Value = Starting Invested Capital + Present Value of (Projected Economic Profit) # this is the same as the DCF model. Think of this as a stacked bar graph where the starting invested capital is the base, and the economic profit is the additional value created on top of the base (which has decreasing height due to time value of money).
Value = FCF at t=1 / (WACC - Growth) # this is the same as the DCF model. Think of this as the present value of the future cash flows.
Growth = ROIC * Investment Rate # this represents growth rate of NOPAT
Cash Flow = Earnings * (1 - Investment Rate) # if you always reinvest at the same rate, your cash flow is always a constant percentage of earnings
Cash Flow = Earnings * (1 - Growth / ROIC) # this is the same as the previous equation
Economic Profit = Invested Capital * (ROIC - WACC) # per year. If we project economic profit at the same rate, we get the same valuation as the DCF model (see above).
Anything that doesn’t increase cash flows does not create value.