Invested Capital Growth is one of the most important forecasts in firm valuation. In this essay, I will explain the fundamentals of invested capital growth, its importance, and how to forecast it. The ROIC shows how efficiently the company is using its invested capital. From the above generic formula, as invested capital is the denominator, we can observe that when the invested capital growth is low, the invested capital figure will be small, causing the ROIC to be high, and vice versa. ICG in its simplest form, can be viewed as the replacement of existing assets plus asset expansion.
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In this paper, the key variables of company valuation, return on invested capital ROIC and revenue growth, are connected to the total returns to shareholders TRS. For a better understanding of this specific field of practice, there will first be a brief explanation of the relevant terms in the next chapter. The value of a company depends mainly on its key drivers, ROIC and revenue growth, both considered over a long-term time horizon. It is defined as after-tax operating profit NOPLAT divided by invested capital, which is the sum of the working capital and the fixed assets Koller et al.
Thus, ROIC shows how successful a company is using its assets to create returns. The result is the economic profitability which differs clearly from the commonly used accounting profitability Patterson The latter one is much easier to compute but it is not showing the true economic situation of a business, as it can be easily manipulated by managers.
On top of that, there are lots of adjustments necessary to arrive from the accounting data at ROIC. Operating profit and invested capital can only be computed after analyzing hundreds of pages of financial statement filings Trainer Another way of looking at ROIC is to use a per unit calculation:.
This formula breaks down NOPLAT into price and cost and therefore implies that a company which can charge a higher price premium, has lower production costs or has to invest lower capital per unit exhibits a higher ROIC which is driven by a competitive advantage.
Hence, industries with scalable returns like software can earn higher ROICs than commodity-dependent industries like utilities. Furthermore, there is evidence that if a company is finding a strategy to deliver a high ROIC, it is likely to sustain it over time Koller et al.
Revenue growth, as the second value driver, can be divided into three components: At first, we have portfolio momentum, which is based on overall market expansion leading to an organic revenue growth of the distinctive market segments. It is important to note, that not all of these growth drivers are creating value equally.
Growth comes always at the expense of another market participant. The scope of the value added depends on the retaliation rate of the losers.
If, for example, market share is won from an established competitor, he can retaliate and take the customer back. Furthermore, simple price increases can be answered by a reduced customer consumption, leading both to lower long-term value.
If on the other hand growth is driven by the creation of a new market through a completely new product, then there are no established rivals and the revenue is taken from distant companies, which are often not able to retaliate. This will be the most valuable option, followed by attracting new customers and convincing existing customers to expand their buying Ibid.
A successful management technique to cope with all those different growth drivers is to conduct a granular approach by dividing the company into hundreds of cells, evolving from the different business lines and regions a firm is operating. Do resources need to be reallocated? Is it time to exit a market altogether? Sustaining high revenue growth rates over a long-term horizon is extremely challenging.
It is only possible by consistently finding new product markets and entering them during the time of the highest growth of their product life cycle. To increase growth rates while the company is already getting bigger in terms of total sales, it is necessary to find new products delivering even more growth.
This is called the portfolio treadmill effect Koller et al. The metric TRS is defined as the sum of the stock price appreciation and the sum of dividends paid to the shareholders over a given period, divided by the beginning share price Kay Furthermore, the market value of any shares received in a spin-off and the relating dividends, as well as the value of any warrants issued on any of the stocks should be regarded Kennon The idea behind that is the aligning of shareholders and managers interest by connecting performance bonuses to TRS.
In reality, the aligning does only work over long periods, e. In a mature business environment, shareholders are normally expecting a further improvement of performance, even if the preceding years have already been very positive. That leads again to the treadmill effect as expectations are growing exponentially.
Secondly, the just mentioned traditional method to compute TRS does not reflect the real operating improvements as a result of senior management activity. The pure focus on dividends and the change in share price can lead to a short-term thinking at the expense of long-term value creation Koller et al. Basically, TRS is driven by the change in economic profit, the above described performance measurement metric Hausmann et al. Generally, there should be a strong positive relationship between companies with high ROIC and revenue growth and their stock market performance, expressed by the previous explained traditional metric TRS, as value creation should be aligned with rising equity valuations leading to higher shareholder returns.
Concerning valuation multiples, it can be stated that a higher ROIC means that there is higher cash flow at the same earnings, which leads to a higher earnings multiple. And if multiples are expanded, shareholder value in terms of TRS is enlarged. Next to that, long-term organic revenue growth is the most important driver of stockholder returns for companies with high returns on capital, i.
Thus, on first sight, the research hypothesis stating that there could be lower TRS in a higher ROIC and growth environment, all else equal, could be clearly rejected. It is important to recognize, that profits, ROIC and revenue growth are all backward looking, and are giving no reliable indicator for future short-term value improvement. If an exemplary company is increasing ROIC and revenue growth by raising prices while cutting advertising budgets, it is very likely that competitors can take market shares in the next period.
The necessary reaction would be a dramatic shift in strategy, lowering prices to win back customers. This process could last many years and would in turn lead to lower TRS as shareholders expectations are not met and returns as well as growth numbers are shrinking Koller et al. Thus, it is important to define the exact time frame, i.
On top of that, company executives should decompose even positive return metrics to understand why the numbers are this extraordinarily high. A H Arno Hetzel Author. Add to cart. Another way of looking at ROIC is to use a per unit calculation: This formula breaks down NOPLAT into price and cost and therefore implies that a company which can charge a higher price premium, has lower production costs or has to invest lower capital per unit exhibits a higher ROIC which is driven by a competitive advantage.
ROIC and revenue growth versus total return to shareholders (TRS)
When building a DCF model, we too often become caught up in the details of. When ROIC is high, growth typically generates additional value. But if ROIC is low, the blind pursuit of growth can often be counterproductive. A balanced. Return on Investment trailing 12 month Market Capitalization My screen produced a list of 5, stocks. You are commenting using your Facebook account. October 22, October 31, Market Fox.
Invested Capital Growth Significance