You will be able to explain why growth adds value only when return on capital is higher than the cost of capital.
A company's annual report shows how much it earned. It does not show how much money had to stay tied up in the business to earn it. Two companies with the same profit can be very different investments if one needs twice as much capital as the other. To judge whether growth is worth having, you need the return on the money in the business, compared with what that money costs.
Return on invested capital (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, which you work out as operating profit x (1 - tax rate). The denominator is invested capital, the money tied up in running the business.
You can build invested capital two ways, and both should give the same figure. From the operating side, add working capital, property and equipment (including right-of-use assets) and goodwill. From the funding side, take equity plus debt and leases, minus cash. Use one as a cross-check on the other. Then divide operating profit after tax by opening or average invested capital, because the profit was earned on the capital in place during the year.
Take Larkspur, with figures in S$ millions. FY5 operating profit is 56 and the tax rate is 17%, so operating profit after tax is 56 less 17% tax, about 46.5. At the end of FY4, working capital is 105, property and equipment 162 and goodwill 30, giving invested capital of 105 + 162 + 30 = 297. On the funding side, equity is 255, debt and leases 92 and cash 50, so 255 + 92 - 50 = 297. FY5 ROIC on opening capital is 46.5 / 297, about 15.6%.
Analysts disagree on details, such as whether to include goodwill and how to treat excess cash. Including goodwill shows the return on what shareholders actually paid, acquisitions included. Excluding it shows the return the operations earn on their own assets. If goodwill is large, calculate ROIC both ways, and use the same definition every year.
Set ROIC beside the WACC from Lesson 8.2, "Cost of capital: equity, debt and a WACC you can defend". Larkspur's WACC is about 9%. Growth at a return above the cost of capital creates value. Growth below it destroys value, however good revenue looks.
To value a piece of growth, multiply the amount invested by its ROIC to get the yearly return, divide that by WACC to value it as a perpetuity, and compare the result with the amount invested. If the value is higher than the amount invested, the growth created value. If it is lower, the growth destroyed value.
Say Larkspur invests another 10 in machines and working capital at 15.6%, rounded to 16%. That earns about 1.6 a year after tax, worth 1.6 / 0.09 = about 17.8. Larkspur spent 10 and created about 17.8, a gain of about 7.8. If the same 10 earns 6%, roughly where coatings sits in a good year, it brings in 0.6 a year, worth 0.6 / 0.09 = about 6.7. Larkspur spent 10 to create 6.7, destroying about 3.3 of value.
Larkspur's coatings business grew revenue every year after the acquisition, and 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, so more growth meant more money tied up in a business earning less than it cost to fund. A company can destroy value this way while reporting higher revenue and higher profit. This is the pay plan question from Lesson 6.5, "Management incentives, ownership and related-party deals". A bonus for revenue growth rewards management for both kinds of growth, the value-creating kind and the value-destroying kind.
When a business earns far above its cost of capital, 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. This is mean reversion. Lesson 7.6 applied it to margins, and it applies to returns in the same way.
Businesses that keep high returns for decades usually have an advantage competitors can't copy quickly. There are four kinds: a brand customers pay more for, a network that becomes more useful as it grows, costs nobody else can match, and customers who find switching painful. Module 9, lesson 9.4, "Competitive position: Five Forces and moats, tested against the numbers", uses the Five Forces and moats frameworks to test for these advantages.
Larkspur's advantage, from Lesson 6.2, is slow supplier qualification. It is real but limited, because it weakens when a customer qualifies a second supplier, and one customer has started to.
Every forecast implies a ROIC for each year: forecast operating profit after tax divided by forecast invested capital. This turns three separate assumptions (margin, capital spending and working capital) into one figure you can compare with the company's historical range, including downturn years. If implied ROIC is far above anything the company has achieved, or keeps rising with nothing to explain it, flag the forecast as too optimistic, since the valuation inherits that optimism.
Marcus's Larkspur forecast keeps margins, capital spending and working capital fixed as a share of revenue. As a result, it implies ROIC of about 16% in every year from FY6 to FY10. That is slightly better than Larkspur's history: 15.6% in FY5 and about 11% in the FY4 downturn, measured on end of FY3 invested capital of about 295. Holding 16% for five years with no downturn assumes Larkspur stays near the top of its own range.
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 past years and five forecast years, then compare each year with your WACC.
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