Fundamental Principles of Value Creation

Ranking the Types of Growth that create value:

1.  Introducing new products to market
2.  Expanding an existing market
3.  Increasing share in a growing market
4.  Acquiring businesses.


High ROIC companies typically create more value by focusing on growth, while lower ROIC companies create more value by increasing ROIC.

Most often in mature companies, a low ROIC indicates

• a flawed business model or 
• unattractive industry structure.

Earnings and cash flow are often correlated, but earnings don't tell the whole story of value creation, and focusing too much on earnings or earnings growth can lead to straying away from the value-creating path.

When ROIC is greater than the cost of capital, the relationship between growth and value is positive.

When ROIC is less than the cost of capital, the relationship between growth and value is negative. 

When ROIC equals the cost of capital, the relationship between growth and value is zero.


With respect to countries, the core valuation principle is applicable, as made evident by the fact that U.S. companies trade at higher multiples than companies in other countries.

When comparing the effect of an increase in growth on a high ROIC company and a low ROIC company, a 1 % increase in growth will have a higher positive effect on the high ROIC company.

At high levels of ROIC, improving ROIC by increasing margins will create much more value than an equivalent ROIC increase by improving capital productivity.

Economic profit is the spread between the return on invested capital and the cost of capital times the amount of invested capital.



Investment rate = Growth / ROIC.   If the growth of a company is 2% and the ROIC is 10%, its investment rate is 20%.


Key Value Driver formula:

Value = NOPLAT * (1 - growth/ROIC) / WACC - growth

For a given company, given:

its next year's NOPLAT is $300
and for the foreseeable future

• its growth rate will be 5%, 
• the ROIC will be 15% and
• the weighted average cost of capital (WACC) will be 13%.

Using the key driver formula, the Value of the Company is:

= $300 * ( 1 - 5%/15%) / 13% - 5%
= $300 * (1/3) / 8%
= $200 / 8%
= $2,500

Recognising Real Value Creation

Data from both Europe and the United States found that companies that created the most shareholder value showed stronger employment growth.

In the past 30 years, there have been at least 6 financial crises that arose largely because companies and banks were financing illiquid assets with short-term debt.

Two activities that managers often use in an attempt to increase share price but that do not actually create value are 

• changes in capital structure (or financing of the firm) and 
• changes in accounting practices.

Maximising current share price is not equivalent to maximising long-term value because managers, who know more than shareholders about the firm's prospects, could slash crucial expenses to improve the stock price in the short term.  Eventually, this will catch up to the firm, and the long term stock price will suffer.

During the Internet boom of the late 1990s, many firms lost sight of value creation principles by blindly getting bigger without maintaining a competitive advantage.

Activities boosting valuation

Numbers reveal behaviour.  So what exactly is value building behaviour in a company?  Here are some ideas:

• A strong management team with longevity.
• Hot products with plenty more in the pipeline - research and development spending that's paying off.
• Customers in a love affair with the company.
• A plant and equipment in top shape.
• Consistent upward trends in revenues and earnings - no big swings or extremes.
• Low employee turnover and high marks for its workplace.
• A wide variety of customers without anyone accounting for more than 5 percent of the company's sales or earnings.
• A history of an appropriate level of advertising.

e.g. Nestle Malaysia.