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While the enhanced earnings-multiple approach works in a simplified world, it begins to break down once we add real-world complications:
• Varying accounting treatments for inventories, depreciation, and other items make it difficult to measure the incremental return on investment consistently across companies.
• Inflation distorts the relationship of accounting earnings to cash flow.
• Cyclicality is not dealt with by the accounting model, which attempts to capture an entire cycle in a single P/E ratio.
• The pattern of investments and their returns is not so simple that investments are made in one year and earn constant returns in all succeeding years.
• The base level of earnings must be normalized to eliminate any nonrecurring items.
We could develop a complex version of the earnings-multiple approach to handle these and other considerations. But in most cases the DCF model is simpler to work with since it already explicitly incorporates important valuation parameters like investment and risk.
Beyond Cash Flow: Growth and ROIC
Discounted cash flows drive the value of a company. Unfortunately, short-term cash flows themselves are not good performance measures. The cash flow in any year (or short period of years) is meaningless and easy to manipulate. A company can delay capital spending or cut back on advertising or research to improve short-term cash flow. Large negative cash flow is not a bad thing if the company is investing to generate even larger cash flows.
Most importantly, cash flows are not intuitive. You can't look at a series of historical or projected cash flows and say what that means. What drives cash flow, as we commented earlier, is the growth of the company (revenues and earnings) and return on invested capital. This is the third issue in our metrics framework.
Using ROIC and growth helps to understand how the levers of value creation may have different impact depending on the current position of businesses. Exhibit 4.8 illustrates how this works for a hypothetical company. The exhibit shows the value of a company with different combinations of projected growth and ROIC. The exhibit assumes a 10 percent cost of capital. A
Exhibit 4.8 How ROIC and Growth Drive Value1
Operating profit ROIC
(annual growth) 7.5% 10.0% 12.5% 15.0% 20.0";,
3% 387 1,000 1,058 1.113 1,170
6% 708 1,000 1,117 1,295 1,442
9% 410 1,000 1,354 1,591 1,886
Value Value Value ?
destruction neutral creation
1 Assumes starting operating prolit = 10G. cost of capital = 10%, and a 25>year horizon after which ROIC = cost ol capital.
company with an already high ROIC creates more value by increasing growth rather than earning ever higher ROICs. Companies earning less than their cost of capital can't create value by growing unless their ROIC moves up above the cost of capital. In fact, additional growth at current ROIC levels actually destroys value.
Here is the historical and projected free cash flow for Heineken, the Dutch brewer:
Historical free cash flow Projected free cash flow
(NLG millions) (NLG millions)
1994 238 1999 446
1995 618 2000 754
1996 (1,035) 2001 800
1997 560 2002 526
1998 364 2003 910
There is not much interesting to say about this series of numbers. But now look at Heineken's performance from the perspective of growth and ROIC.
Actual 1994-98 Projected 1999-2003 (percent) (percent)
Revenue growth 8.5 5.6
EBITA growth 12.9 6.6
ROIC (after goodwill) 12.3 12.3
With this information, we can understand intuitively how Heineken is performing. We can assess its growth relative to the industry. We can evaluate whether its ROIC is improving or deteriorating and how it compares with other branded consumer products companies. Companies need to be cautioned, however, about shifting their focus entirely to ROIC and ignoring growth. An unbalanced focus on ROIC can lead to harvesting behavior, leaving a company out of the race for long-term growth.
Returning to the Sears and Wal-Mart comparison, Exhibit 4.9 plots the revenue growth and return on invested capital for Sears and Wal-Mart between 1995 and 1997. (Before 1995, Sears' performance was distorted by its ownership of Dean Witter Discover and Allstate Insurance.) Over the period, Wal-Mart's revenue growth averaged 12.6 percent a year compared with 7.7 percent for Sears, and its return on capital averaged 14.2 percent against Sears' 10.4 percent. Both companies' cost of capital was about 9 percent. Wal-Mart achieved higher growth and higher returns on capital.
How can it be that Sears earned higher TRS than Wal-Mart when its underlying performance was so much poorer? The answer goes back to the treadmill. Sears was not expected to do well, but did better than expected. Wal-Mart, on the other hand, was the victim of high expectations. It probably earned more economic profit than any other retailer in the world, while sustaining high growth. But the market expected even better.
We can also compare historical performance to the expected performance implied by the market. Exhibit 4.10 shows both the historical results of the two companies as well as a line showing the combinations of future growth and return on invested capital that are consistent with today's market value. These lines represent the level of performance needed to meet market expectations. If a company delivers this level of performance, its share price should rise in line with its cost of equity less the dividend yield (assuming the market as a whole moves in line with expectations). If it exceeds expectations, its share price should rise more quickly. Wal-Mart is expected to perform considerably better than Sears, and even better than it has done in the years to 1998. For Sears, the opposite is true. The market does not appear to expect it to perform as well as it has in recent years.