You will be able to explain why growth only adds value when return on capital beats the cost of capital.
Larkspur's coatings business grew its revenue every year after the acquisition. The chief executive pointed to that growth in every results briefing. But coatings earned almost nothing on the S$30 million of goodwill and the plant behind it, and more growth meant more money tied up in a business earning less than it cost to fund. Growth sounds like good news. Whether it is depends on one comparison.
Figures are made up and in S$ millions.
Return on invested capital, or ROIC, measures how much operating profit, after tax, a business earns on the capital tied up in it.
The numerator is operating profit after tax, sometimes called NOPAT. For Larkspur's FY5: operating profit of 56, less tax at 17%, is about 46.5.
The denominator is invested capital: the money tied up in running the business. Work it out from the operating side as working capital, plus property and equipment including right-of-use assets, plus goodwill. At the end of FY4, Larkspur had working capital of 105, property and equipment of 162 and goodwill of 30, for invested capital of 297. You can check it from the funding side too: equity of 255, plus debt and leases of 92, minus cash of 50, is also 297.
ROIC uses opening or average invested capital, since the profit was earned on capital in place during the year. On opening capital, Larkspur's FY5 ROIC is 46.5 divided by 297: about 15.6%.
Analysts argue about details, such as whether to include goodwill or how to treat excess cash. Including goodwill shows the return on what shareholders actually paid, acquisitions and all. Excluding it shows the return the operations earn on their own assets. Calculate it both ways if goodwill is large, and use the same definition every year.
Compare ROIC with the WACC from lesson 8.2, Cost of capital: equity, debt and a WACC you can defend. Larkspur earns about 15.6% on capital that costs about 9%.
Now think about what growth does. Suppose Larkspur invests another 10 in machines and working capital. At its current 15.6% return, rounded to 16%, the investment earns about 1.6 a year after tax. Investors demand 9%, so a stream of 1.6 a year for ever is worth 1.6 divided by 0.09, about 17.8. The company spent 10 and created about 17.8 of value: a gain of about 7.8.
Now suppose the same 10 earns only 6%, which is roughly where the coatings business sits on a good year. That's 0.6 a year, worth 0.6 divided by 0.09, about 6.7. The company spent 10 and created 6.7. It destroyed about 3.3 of value, while reporting higher revenue and higher profit.
So growth at a return above the cost of capital creates value, and growth below it destroys value, however good the revenue chart looks. That's the logic behind the pay plan question in lesson 6.5, Management incentives, ownership and related-party deals: a bonus for revenue growth pays management for both kinds.
If a business earns far more than its cost of capital, others notice. Competitors enter, customers push for lower prices, and suppliers ask for more. Over time, in most industries, returns tend to drift back towards the cost of capital, the same mean reversion lesson 7.6 applied to margins.
Some businesses hold high returns for decades. They usually have an advantage that competitors can't copy quickly: a brand customers pay more for, a network that grows more useful as it grows, costs nobody else can match, or customers who find switching painful. Module 9 tests for these in lesson 9.4, Competitive position: Five Forces and moats, tested against the numbers.
Larkspur's advantage is the slow supplier qualification from lesson 6.2. It's real, but limited: a customer that qualifies a second supplier, as one has started to, chips away at it.
Now apply this to your model. Every forecast implies a ROIC for each year: forecast operating profit after tax divided by forecast invested capital.
Marcus's Larkspur forecast implies ROIC of about 16% in every year from FY6 to FY10, because margins, capital spending and working capital all stay fixed as a share of revenue. Against history, that's a little better than average. FY5 was 15.6%, and in the FY4 downturn ROIC fell to about 11%, on invested capital of about 295 at the end of FY3. A forecast that holds 16% through five years, with no downturn, is assuming Larkspur stays near the top of its own range.
That's the value of the check. It turns three separate assumptions, about margin, capital spending and working capital, into one figure you can compare with the company's record. If the implied ROIC is far above anything the company has achieved, or keeps rising with nothing to explain it, the forecast is too optimistic, and your valuation will inherit the optimism.
For the activity, calculate your company's ROIC for five historical and five forecast years and set each year beside your WACC.
Calculate your company's return on invested capital for five historical and five forecast years and compare it with your WACC.
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