Principles of Value Creation
Value creation is process of generating wealth or economic value for a firm by surpassing customer expectations and delivering a high return on investment for shareholders. The core principles encompass aligning all activities to a shared goal, investing capital at a rate that surpasses its cost, generating robust cash flow, and balancing growth with a aim on sustainable and profitable returns. The principles of value creation require consistent renewal of competitive advantages, adapting to market changes, leveraging technological advancement to boost growth.
The amount of value companies create is the difference between cash inflows and the cost of investment incurred, adjusted to reflect the fact that tomorrow’s cash flows are worth less than today’s due to the time value of money and the riskiness of future cash flows.
Return on Invested Capital (ROIC) Impacts on Value Creation
ROIC is financial ratio that ascertains a firm’s profitability and ability to create value from its invested capital. It is computed by dividing a firm’s operating profit after taxes (NOPAT) by its average invested capital (debt, equity and other long-term funding).
ROIC = NOPAT/Average Invested Capital
OR
ROIC = EBIT / (Average Net Debt + Equity)
ROIC per Unit = (1-Tax Rate) x (Price per Unit – Cost per Unit) / Invested Capital per Unit
ROIC indicates:
- Value creation: A firm is creating value if its ROIC is higher than its WACC.
- Value destruction: If the ROIC is less than the WACC, the firm may be eroding value.
- Efficiency: ROIC indicates how efficiently a firm uses its total capital to generate profits.
- Growth: ROIC helps to determine a firm’s maximum self-sustaining growth rate without external funding.
- Competitive advantage: By examining a firm’s ROIC over time, investors can evaluate the durability of its competitive advantages.
- Comparison to WACC:The most significant use of ROIC is to compare it to a firm’s WACC to understand if it is creating value. A benchmark for value creation is an ROIC that is at least 2% greater than the WACC.
- Limitations:It may be complex for some to calculating ROIC accurately owing to factors, such as leasing, research and development costs, or accounting write-offs. ROIC can as well be complicated to analyze for firms with diverse business segments.
Cash Flow Impacts on Value Creation
A Cash flow represents the movement of money into and out of a firm over specific period. Cash flow influences value creation by furnishing a business with the liquidity to operate, grow, and invest. A robust cash flow allows for funding of strategic chances, the possibility to optimize business operations, and the ability to settle financial challenges, ultimately generating a more valuable and sustainable firm. Contrarily, deficient cash flow, even in a profitable firm, can preclude growth and lead to financial distress.
How Cash Flow Create Value
- Funds Growth and Investment
Positive cash flow from operations generates excess cash that can be ploughed back into new products, services, or strategic opportunities, driving future growth.
- Enhances Operational Efficiency
By managing cash flow, businesses can optimize their working capital- the difference between current assets and liabilities- to speed up cash generation and upgrade financial health.
- Creates Financial Stability
Constant cash flow shows a firm’s ability to meet its obligations, which improves its creditworthiness, attracts investors, and builds trust with suppliers and customers.
- Augments Investor Returns
Optimizing cash flow can speed up cash generation, allowing for earlier distributions to investors and creating opportunities for reinvestment to improve returns.
- Brings about Strategic Decisions
The Risks of Weak Cash Flow
- Hampers Growth:
A negative cash flow can hinder or suspend expansion plans and force a business to focus solely on staying afloat, precluding it from capitalizing on new opportunities.
- Causes Insolvency:
A firm can be profitable on paper but still fail if it lacks the cash to meet financial obligations owing to late payments or other cash flow issues.
- Erode Relationships:
Cash Flow Perpetuity
A cash flow perpetuity is a stream of similar cash flows that continues indefinitely, with no end date. In valuation of analysis, perpetuities are used to calculate the present value of a firm’s future projected cash flow stream and the firm’s terminal value.
Cash Flow Perpetuity formula:
Value = FCF / (WACC- g)
Where:
FCF = Free Cash Flow
WACC = Weighted Value of Cost of Capital
g = growth
Growth Impacts on Value Creation
Growth influences value creation by upscaling a company’s overall worth, particularly when it is profitable. Growth creates value when the return on invested capital exceeds the cost of capital, which often occurs by increasing revenues. Conversely, growth can decline value creation if a business is not profitable, or example, securing excessive debt to fund it without a positive return on equity.
Ultimately, a company’s specific mission, governance, and strategic approach determine whether growth leads to sustainable, multi-stakeholder value or creates negative consequences.
Growth Rate = (Current Value – Previous Value) / Present Value x 100
Compound Annual Growth Rate (CAGR) = ((EV/BV)1/n – 1) x 100
- Amplified value creation:
Growth can amplify a firm’s existing value creation mechanisms and give rise to new ones, making it a powerful driver for stakeholders.
- Expanded capabilities:
High-growth firms can expand the capability sets of their stakeholders, creating new opportunities and benefits.
- Increased shareholder value:
Studies have shown a link between organic revenue growth and increased shareholder value, with a significant long-term impact on the total return to shareholders.
- Economic contribution:
High-growth firms are significant contributors to overall economic growth, creating jobs and driving innovation.
- Strain on resources:
Rapid growth can put immense pressure on a firm’s limited resources, potentially leading to negative outcomes.
- Value destruction risks:
Unmanaged growth can lead to value destruction, particularly from ineffective succession planning, internal conflicts, and a resistance to necessary innovation.
- Focus on shareholder value:
A narrow focus on growth can lead some firms to prioritize shareholder value over the interests of other stakeholders, creating social value deficits.
- Firm mission and attributes:
A company’s mission, its overall attributes, and how it approaches its goals importantly affect whether growth creates value or not.
- Governance and strategy:
Effective governance and strategy are significant. They can be used to reduce the risks of value destruction and guide growth towards positive outcomes for all stakeholders.
- Balance with profitability:
There is an optimal point for growth; beyond it, further expansion can actually harm profitability and destroy value, highlighting the need to balance growth with efficiency and profitability.
- Innovation and adaptability:The ability to innovate and adapt is essential. Companies that fail to innovate will see their products become obsolete, and firms that resist innovation may experience value destruction.
Net Operating Profit Less Adjusted Taxes (NOPLAT)
NOPLAT is a firm’s profitability after deducting taxes; however, before accounting for interest expenses. It constitutes the profit generated from a firm’s core operations, unaffected by its capital structure (i.e., how it is financed).
NOPLAT = Earnings Before Interest Taxes x (1 – Tax Rates)
OR
NOPLAT = Invested Capital x ROIC
NOPLAT impacts value creation by providing a clearer measure of a firm’s operational profitability, which is used to compute Economic Value Added (EVA). A positive EVA, derived from NOPAT, suggests the firm is generating value above its cost of capital, while a negative EVA indicates value destruction. High NOPAT signals strong key performance and is used by investors to evaluate operational risk and predict future returns, enhance business creditability, and make better investment decisions.