Value Creation

It is often talked about in almost every company. It is the buzz word around which many training courses are often designed and company people are sent for training. Therefore, every company today work in pursuit of what they call value creation. But what is it and is it possible to measure?

Companies create value for their owners and stakeholders investing cash into the company by generating more cash in the future. In other words, value creation is the strategic direction provided by the company leadership in order to achieve competitive advantage resulting in measurable Growth and Return on Invested Capital (ROIC).

For creating value companies need to think differently. As Warren Buffet said “Difficulty lies not in the new ideas but escaping from the old ones.” It is this psychological barrier that companies needs to overcome when they think strategy to achieve competitive advantage and accelerate growth and achieve higher ROIC.

Below I have tried to express in short the relationship between the Growth, ROIC & Value though mathematical equations.

Net Investment* = Invested Capital(t+1) – Invested Capital(t)*Net Investment is the increase in invested capital from one year to the next

FreeCash Flow (FCF )∗¿NOPAT−Net investment *FCF = Cash Flow generated by the core operations of the business after deducting investments in new capital

ROIC∗¿ NOPATInvested Capital

*ROIC is the return the company earns on each Re invested in the business*ROIC can be defined as return on all capital OR as the return on new or incremental capital

Investment Rate ( IR )=Growth(g)× Returnon InvestedCapital (ROIC )

Investment Rate ( IR )=Net InvestmentNOPAT

*The portion of NOPAT invested back into the business

Weighted Average Cost of Capital (WACC)* *WACC – is 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 (FCF)

Growth (g)* *g is the rate at which the company’s NOPAT and cash flow grow each year

ROIC= (1−Tax Rate ) x Price per unit−Cost perunitInvested Capital

Assumption:1. Company’s revenue and NOPAT grow at a constant rate2. The Company invests the same proportion of its NOPAT in its business each year3. The Company FCF grows at a Constant rate

Value=( FCF t=1WACC−g )FCF=NOPAT−Net InvestmentFCF=NOPAT−(NOPAT x IR )FCF=NOPAT x (1−IR )

FCF=NOPAT x (1− gROIC )

Value=NOPAT t=1(1− g

ROIC )WACC−g

The above Formula underpins the DCF approach to Valuation

ValueNOPAT t=1

=(1− g

ROIC )WACC−g

ValueInvested Capital x ROIC

=(1− g

ROIC )WACC−g

Value=InvestedCapital x ROIC x (1− g

ROIC )WACC−g

Dividing both sides by invested capital

ValueInvested Capital

=ROIC ( (1− gROIC )

WACC−g )

Return on Invested Capital is linked to Competitive Advantages of the company which in turn is linked to Business Strategy.

The above equation shows that the ROIC can be improved either by increasing the Price or reducing the cost of production by being efficient.

Competitive AdvantagePrice Premium Advantage (Improve the Price per Unit Side of Formula)

1. Innovative Products2. Quality3. Brand4. Customer Lock-in5. Price Rational and Discipline

Cost & Capital Efficiency Advantage1. Innovative Business Method2. Unique Resource3. Economy of Scale4. Scalable Product/Process

Sustainability of Return on Invested Capital1. Length of Product life Cycle2. Persistence of Competitive Advantage3. Potential of Product Renewal

In my next article I will develop the strategic vision to the value creation.