Chapter 3: Value

Lecture 3.5: Long Term Value Drivers

 ROIC is the return that companies are able to get from their investments. Some companies have achieved
extraordinary value creation by finding investment opportunities that allowed them to yield fabulous returns – high
ROICs.

 However, the problem with yielding fabulous returns is that this will attract other investors, which will in turn drive up
competition and force companies to decrease their rate of return (usually in the form of a lower profit margin driven
by lower prices).

 Can a company stop this effect? Yes, if it has relevant competitive advantages over those competitors.

 This means we have two essential ROIC determinants: 1) whether or not companies have a competitive advantage
and 2) the sector in which they operate.
 Price Premium Cost and Capital Efficiency
Innovative products: difficult to copy or Innovative business method: difficult to copy
patented products services or technologies business method that contrasts with established
industry practice
Quality: customers willing to pay a premium for a Unique resources: advantage resulting from
real or perceived difference in quality over and inherent geological characteristics or unique
above competing products or services access to raw materials

Brand: customers willing to pay a premium based Economies of scale: efficient scale or size for the
on brand, even if there is no clear quality difference relevant market

Customer Lock-In: customers unwilling or unable Scalable product/ process: ability to add
to replace product or service they use with a customers and capacity at negligible marginal cost
competing product or service

Rational price discipline: lower bound on prices

established by large industry leaders through price
signaling or capacity management

Source: McKinsey Valuation

 difficult to copy or patented products
Innovative products services or technologies

customers willing to pay a premium for a

real or perceived difference in quality over
Quality and above competing products or services

customers willing to pay a premium based

Brand on brand, even if there is no clear quality
difference

customers unwilling or unable to replace

Customer Lock-In product or service they use with a competing
product or service
lower bound on prices established by large
industry leaders through price signaling or
Rational price discipline capacity management

Source: McKinsey Valuation

 difficult to copy business method that
Innovative business method contrasts with established industry
practice

advantage resulting from inherent

geological characteristics or unique
Unique resources access to raw materials

efficient scale or size for the relevant

Economies of scale
market

ability to add customers and capacity at

Scalable product/ process negligible marginal cost

Source: McKinsey Valuation

 ROIC is the return that companies are able to get from their investments. Some companies have achieved
extraordinary value creation by finding investment opportunities that allowed them to yield fabulous returns – high
ROICs.

 However, the problem with yielding fabulous returns is that this will attract other investors, which will in turn drive up
competition and force companies to decrease their rate of return (usually in the form of a lower profit margin driven
by lower prices).

 Can a company stop this effect? Yes, if it has relevant competitive advantages over those competitors.

 This means we have two essential ROIC determinants: 1) whether or not companies have a competitive advantage
and 2) the sector in which they operate.
  Despite the clear industry
differentiation, there is
still some degree of
diversification of ROIC
within each industry.

 Unsurprisingly, the ones

where that effect is more
clear are the ones that
allow more competitive
advantages to arise
(software vs. electric
utilities)

Source: McKinsey Corporate Performance Center Analysis

Source: McKinsey Corporate Performance Center Analysis
1. First and foremost, it is reasonable to expect the company’s ROIC to fall within the industry range, so looking at that interval is
always a good starting point.

2. However, in some sectors this is still quite a large interval to narrow it down to a value. Looking at the sources of competitive
advantage that a firm may have is thus the next logical step.

3. Is it reasonable to expect companies to sustain those competitive advantages over the long run? For the average company,
probably no – there will be a natural regression towards the mean. However, studies also show that companies that benefit from
competitive advantages today will probably erode some of the superior ROIC but, for the most part, they will still be some of the
top performers in the industry.

4. Economic theory suggests that competition will eventually eliminate abnormal returns, so for many companies, set ROIC equal to
WACC. However, for companies with sustainable competitive advantages (e.g., brands and patents), you might set ROIC equal to
the return the company is forecast to earn during later years of the explicit forecast period.
Current Prices vs Fixed Prices

• Either (i) you discount current prices FCF at nominal discount rates (alternative suggested and more intuitive), or (ii) you
discount constant prices FCF at real discount rates (less intuitive and more prone to mistakes).
• Most people discount the free cash flows at nominal discount rates – i.e. based on a nominal Risk Free rate (Rf), nominal
Opportunity Cost of Debt (Rd), etc., as opposed to real discount rates, the nominal ones include an anticipated inflation.
• Thus, to be consistent, your FCF should be projected at current prices (as opposed to fixed prices), which means including the
anticipated inflation – the one that is also implicit in the discount rates.
• Remember that your “g” – the long term growth rate of these free cash flows – should thus also be a nominal rate. Thus, as
a sanity check when estimating it, you can break it down between
i. expected real long term growth, which may be compared to the economy’s real long term growth rate and
ii. expected long term inflation
  The median rate of
revenue growth between
1963 and 2007 was 5.4% in
real terms.

 But this value shows

considerable fluctuation,
even within the same
industry!

 While industry metrics may

be checked on, their
usefulness to forecast
growth is limited.

Source: McKinsey Corporate Performance Center Analysis

Source: McKinsey Corporate Performance Center Analysis
Value Created Type of Growth Rationale

• Create new markets through new • No established competitors

products
Above Average • Convince existing customers to buy more
of a product • All competitors benefit, which means
there is no risk of retaliation
• Attract new customers to market

• Gain market share in fast growing market • Competitors can still grow despite losing
share, which means there is moderate risk
Average of retaliation
• Make acquisitions to accelerate product • Modest acquisition premium relative to
growth upside potential
• Gain market share from rivals through • Competitors can replicate and take back
incremental innovation customers
Below Average • Gain share from rivals through product • Competitors can retaliate quickly
promotion and pricing
• Make large acquisitions • High premium to pay
Finding actual growth opportunities that can be value added over a reasonable period is extremely
difficult.

The only feasible way seems to be to keep producing new products and enlarging the market
but, by definition, that has limits.

Growth is very difficult to sustain (even harder than ROIC) so most companies regress
towards the normal level of economic growth.
High growth rates decay very quickly. Companies growing faster than 20 percent (in real terms)
typically grow at only 8 percent within five years and at 5 percent within 10 years.
Extremely large companies struggle to grow. Excluding the first year, companies entering the
Fortune 50 grow at an average of only 1 percent (above inflation) over the following 15 years.
Source: McKinsey Corporate Performance Center Analysis
Source: McKinsey Corporate Performance Center Analysis
1. Looking at the industry level of growth can be useful in the short term but it is, for the most part, an unreliable measure when it
comes to the terminal value, seeing how much industry levels of growth also shift and considering the high variability within each
industry.

2. To understand whether or now a company will be able to sustain a growth position, understanding the source of that growth is
very much relevant. Growth based on expanding the market is more lasting than growth based on trying to grow at the expense
of competitors.

3. Even so, sustaining high growth is even a higher challenge than initiating it. Because most products have a natural life cycle, the
only way to achieve lasting high growth is to continue introducing new products at an increasing rate – which is just about
impossible.

4. While it reasonable to expect growth during reasonable periods of time, for the most part, companies shouldn’t be expected to
perpetually (which is the idea behind terminal value) outperform the economy – not only because that doesn’t seem to be
achievable but also because that would mean companies would become the economy themselves at some point. Assuming the
average sector growth rate for a while may be reasonable but, sooner or later, the average economy growth should be assumed.
 Many financial analysts routinely assume that the incremental return on capital during the continuing-value
period will equal the cost of capital. This practice relieves them of having to forecast both a ROIC and also a
growth rate, since growth in this case neither adds nor destroys value.
For some businesses, this assumption is too conservative. For example, both Coca-Cola’s and PepsiCo’s soft-
drink businesses earn high returns on invested capital, and their returns are unlikely to fall substantially as they
continue to grow, due to the strength of their brands. An assumption that ROIC equals WACC for these
businesses would understate their values.

 However, remember that even when ROIC remains high, growth will probably eventually drop as the
market matures. Therefore, any assumption that ROIC is greater than WACC should be coupled with an
economically reasonable growth rate.