Return on invested capital and forecasting

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Module Code: C364

Assignment: TMA01

Word Count: 2,449 words

Part (a)

Introduction

According to Koller et al. (2010), ‘value is the defining dimension of measurement in a market economy.’ And that ‘value is a particularly helpful measure of performance because it takes into account the long-term interests of all the stakeholders in a company, not just the shareholders.’ Corporations create value by investing capital raised from investors which is used to generate future cash flows at rates of return exceeding the cost of capital. The faster companies can increase their revenues and deploy more capital at attractive rates of return, the more value they create. The combination of growth and return on invested capital (ROIC) relative to its costs is what drives value. Companies can sustain strong growth and high ROIC only if they have a well-defined competitive advantage. This is how competitive advantage, the core concept of business strategy, links to the guiding principle of value creation. To answer the question at hand, we will look at the drivers of ROIC and how competitive advantage is linked to ROIC, the sustainability of ROIC, the drivers of revenue growth, how growth is linked to value creation, how we can sustain growth and finally conclude by summing up our argument.

Drivers of ROIC: Competitive Advantage

We have seen in the introduction above that ROIC and growth are the drivers of value. We now look at what are the drivers of ROIC. Let us consider the following representation of ROIC:

ROIC= (1 – Tax Rate) x [(Price per Unit – Cost per Unit)/Invested Capital per Unit]

If a company has a competitive advantage, it earns a higher ROIC, because it either charges a premium price for its products (i.e. increasing the Price per Unit) or produces its products more efficiently (i.e. reducing its Cost per Unit): both components of the numerator in the ROIC formula above. Companies will therefore need to choose strategies that give them competitive advantages against their competitors in an industry. There are five sources of competitive advantage for companies charging a premium price and four sources for cost and capital efficiency. We will look at these briefly below. The price premium advantages mean that companies should be able to distinguish/differentiate their products from their competitors. These advantages include:

i) Innovative products – the only way that innovative products are able to command a higher price is if they are protected by patents. If they are not, it is easy for competitors to swoop in with copies of the product hence driving price down. An example of companies that rely on this advantage are pharmaceutical companies.

ii) Quality - Koller et al. (2010) define quality as ‘a real or perceived difference between one product or service and another for which consumers are willing to pay a higher price.’ An example is German cars like BMW or Volkswagen who are able to command higher prices for their cars due to the fact that consumers perceive their cars to be of higher quality in terms of safety and technology.

iii) Brand – quality and brand may seem undistinguishable, however we can see price premiums of brands that have lasted a very long time for e.g. Coca Cola, Mercedes-Benz or Lacoste.

iv) Customer lock-in – If replacing a company’s product is costly for consumers, the company can charge a price premium. For e.g. Bloomberg financial terminals are leaders in the market simply due to the fact that everyone uses them even though they are of an older technology and customers are not willing to change their terminals and learn the new systems.

v) Rational price discipline – this deals with companies in an industry that automatically set prices at a level that earns them reasonable returns. This mostly works when there is a market leader which sets the price level and others follow. However, even cartels like OPEC find it difficult to maintain price levels over long periods.

Cost and capital efficiencies are two separated competitive advantages, however both have four common sources of gaining the advantage. These include:

i) Innovative business method – A company must have an innovative business method which is the combination of its production, logistics and pattern of interaction with customers. For e.g. Dell had this advantage in the early years of its life.

ii) Unique resources – companies which have access to a unique non-replicable resource gives them a significant competitive advantage. An example includes mining companies.

iii) Economies of scale – companies that benefit from economies of scale have a competitive advantage.

iv) Scalable product/process – products or processes that are scalable result in lower costs of supplying or serving additional customers. Tech companies can normally benefit from this advantage.

Sustainability of ROIC

In short, there are three ways in which companies can maintain a high ROIC. First, sustaining high ROIC is associated with locking in customers with a long product life cycle. An example is that of Microsoft Windows where people find it difficult to move from them since they find they can’t work without it or find it easier to use. Second, sustaining high ROIC is difficult with any competitive advantage if the company cannot prevent competition from duplication by rivals. Third, product innovation and expansion into new product lines may be helpful in maintaining high ROIC. An example is that of Apple who keep on bringing out new and innovative products like the iPod, iPhone, iPad and iWatch so customers stay loyal to them. In addition to all the above factors impairing the sustainability of ROIC, external market factors may also cause the company problems.

Drivers of Revenue Growth and Link with Value Creation

Growth is the next component of the drivers of value creation. Growth can be disaggregated into three components:

i) portfolio momentum – overall market expansion,

ii) market share performance – gaining/losing market share is another source of organic growth,

iii) mergers and acquisitions – an inorganic source of revenue growth.

The first and second points account for most of the revenue growth in typical global companies. However, different companies use difference methods to maintain a there growth.

In terms of value creation, portfolio momentum is a relatively longer-run strategy than market share performance. Therefore, a company should position itself in fast-growing markets. The reason for this is that creating value through market share performance would not be sustainable. If the company increase price to increase market share, it may cause a backlash from consumers while decreasing the price to increase market share may cause a retaliation from competitors. Acquisitions, on the other hand, only create value if the cost of acquisition is not too high and large acquisitions in practice do not create revenue growth. Portfolio momentum especially through new product innovation has the highest potential to value creation especially if it generates a large competitive advantage. This point shows us how competitive advantages are also linked to revenue growth and not only high ROIC.

Sustaining Growth

Sustaining revenue growth is a challenge. High growth companies tend towards an eventual slowing down unless they implement some sort of innovation or new production strategy. Product life cycles is one reason for this challenge. The competitive advantages over a company’s competitors come into play here as well to help them sustain their revenue growth.

Conclusion

We have seen from our discussion above, the ways in which competitive advantage and growth contribute to an understanding of value creation. Competitive advantage is not a driver of value creation but instead it is a driver of ROIC which is in turn a driver of value creation. Growth is however, a driver of value creation however sustaining this growth requires a company of effectively have a competitive advantage over rivals which makes competitive advantage important for this aspect as well.

Part (b)

Introduction

Although the future is unknowable, careful analysis can yield insights into how a company may develop. We will first start by discussing the proper length and detail of a forecast. Then we will start with building a well-structured spreadsheet model. Next we will look at the process of forecasting with some issues it has. We will then look at the continuing value and some cautions about the same.

Length and Detail of the Forecast

The first step in forecasting is to determine how many years to forecast and how detailed the forecast should be. The most common thing to do is to develop an explicit forecast for a number of years and then value the remaining years using the continuing value method which assumes a steady-state performance. Therefore, the explicit forecast period must be long enough for the company to reach a steady state.

Spreadsheet Model

To combine financial forecasting with an historical analysis, we need a set of well-organised worksheets for the valuation model using a spreadsheet software. Many designs are possible, but a few worksheets include: raw historical data, integrated financial statements, historical analysis and forecast ratios, market data and weighted average cost of capital (WACC), reorganised financial statements, ROIC and Free Cash Flow (FCF) and a valuation summary. We, however, need to be careful how we organise the flow of information between different worksheets and not to use built-in formula in spreadsheet software.

Mechanics of Forecasting

The forecasting process can be broken into six steps and we will look at each on in turn:

i) Prepare and analyse historical financials – Before forecasting future financials, we must build and analyse historical financials into a spreadsheet programme. To do this, one may rely on data from a professional service or use financial statements directly from a company’s filings. However, using a professional service carries a cost and building a model using the financial statements/raw data means one has to dig.

ii) Build the Revenue Forecast – To build revenue forecasts, we can use a top-down forecast, i.e. you estimate revenues by sizing the total market, determining market share and forecasting prices, or use a bottom-up forecast, i.e. use the company’s own forecasts of demand from existing customers, customer turnover, and the potential for new customers. Top-down forecasts can be applied to any company since it uses market information, on the other hand a bottom-up forecast needs information from the company itself. A bottom-up forecast basically combines revenues from new customers with those from existing customers. Koller et al. (2010) suggest that extra emphasis should be given to revenue forecasts since every line items in the spreadsheet will be either directly or indirectly driven by revenues. Regardless of the method of forecasting used, revenue forecasts over a long time period will be imprecise. Externalities may affect revenues and they have to be taken into consideration and the forecast must be constantly re-evaluated.

iii) Forecast the Income Statement – Next we need to forecast individual line items related to the income statement. There is a three-step process to forecast a line item:

1. Decide what economic relationships drive the line item,

2. Estimate the forecast ratio, and

3. Multiply the forecast ratio by an estimate of its driver.

iv) Forecast the Balance Sheet: Invested Capital and Non-operating Assets – Next we need to forecast the balance sheet and we start by first forecasting the invested capital and non-operating assets. While forecasting the balance sheet, one of the first issues faced is whether to forecast in stocks, i.e. forecasting line items in the balance sheet directly, or in flows, i.e. indirectly by forecasting changes. Koller et al. (2010) favour the stock approach since ‘the relationship between the balance sheet accounts and revenues (or other volume measures) is more stable than that between balance sheet changes and changes in revenues.’

v) Forecast the Balance Sheet: Investor Funds – To complete the balance sheet forecast, we need to forecast the company’s source of financing. We have to rely on the rules of accounting to do this.

vi) Calculate ROIC and FCF – Once we have completed forecasting the income statement and balance sheet, we calculate the ROIC and FCF for each forecast year. This is relatively easy to calculate if we have already computed ROIC and FCF historically as mentioned above.

Additional Issues in Forecasting

First, in industries where prices are changing or technology is advancing, forecasts should incorporate non-financial ratios, such as volume and productivity. For example, breaking down the forecast of costs as a percentage of revenues, we could forecast costs as a function of expected quantity; we can break down the forecast total labour costs as a percentage of revenues using forecast units per employee, together with average salary per employee. Second, when valuing projects, it is important to distinguish between fixed costs and variable costs. Third, the expected inflation rate used in the financial forecast and cost of capital should be made consistent.

Continuing Value

To estimate a company’s value, we add the Present Value of Cash Flow during the Explicit Forecast Period with the Present Value of Cash Flow after the Explicit Forecast Period. For forecasts after the explicit forecasting period, we need to estimate the continuing value. Here we use either of the two recommended formulas for calculating the continuing value i.e. Discounted Cash Flow (DCF) Valuation or Economic-Profit Valuation.

Practical Cautions about Continuing Value

First, in choosing the length of explicit forecast period, we should make sure that it covers the whole transition period of a company towards its steady state. Close examination of the RONIC and WACC over the explicit forecast period and the continuing-value period is helpful. Second, setting the RONIC equal to WACC after the explicit forecasting period does not imply zero value creation – we need to think carefully about the rate of return on the original capital. Third, large continuing value relative to the total value does not necessarily mean the majority of value is created in the continuing period – e.g. comparing the FCF approach and economic-profit approach may provide a different interpretation. Fourth, it can be misleading to make a simple extrapolation from base year values, (the base year for calculating continuing value will be the final year of the explicit forecast period).

Conclusion

We have seen above the method of estimating the value of a company. We looked at the length of the forecast which explained the explicit period and fro there we went into the method of forecasting the explicit period through the various steps mentioned in the Mechanics of Forecasting above. We then looked at some issues in forecasting the explicit period. We then went on to look at the continuing value and discussed the practical cautions that should be known when calculating the continuing value.

References

Baghai, M., Smit, S. and Viguerie, P. (2009). Is your growth strategy flying blind?Harvard Business Review, p.86–96

Koller, T., Goedhart, M. and Wessels, D. (2010).Valuation: Measuring and Managing the Value of Companies. 5th ed. John Wiley & Sons.

The Economist, (2010) ‘Online grocers – Keep on trucking’

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