Some Lessons  25 Some Lessons While we have simplified the story of Lily and Nate’s business, it highlights the core ideas around value creation and its measurement: 1. In the real market, you create value by earning a return on your invested capital greater than the opportunity cost of capital. 2. The more you can invest at returns above the cost of capital, the more value you create. That is, growth creates more value as long as the re- turn on invested capital exceeds the cost of capital. 3. You should select strategies that maximize the present value of future expected cash flows or economic profit. The answer is the same regard- less of which approach you choose. 4. The value of a company’s shares in the stock market equals the intrinsic value based on the market’s expectations of future performance, but the market’s expectations of future performance may not be same as the company’s. 5. The returns that shareholders earn depend on changes in expectations as much as on the actual performance of the company. In the next chapter, we develop a more formal framework for understand- ing and measuring value creation. 27 3 Fundamental Principles of Value Creation Companies create value for their owners by investing cash now to generate more cash in the future. The amount of value they create is the difference be- tween cash inflows and the cost of the investments made, adjusted to reflect the fact that tomorrow’s cash flows are worth less than today’s because of the time value of money and the riskiness of future cash flows. As we illustrated in Chapter 2, the conversion of revenues into cash flows—and earnings—is a function of a company’s return on invested capital (ROIC) and its revenue growth. That means the amount of value a company creates is governed ul- timately by its ROIC, revenue growth, and ability to sustain both over time. Keep in mind that a company will create value only if its ROIC is greater than its cost of capital.1 Moreover, only if ROIC exceeds the cost of capital will growth increase a company’s value. Growth at lower returns actually reduces a company’s value. Exhibit 3.1 illustrates this core principle of value creation.2 Following these principles helps managers decide which strategies and in- vestments will create the most value for shareholders in the long term. The prin- ciples also help investors assess the potential value of companies they might consider investing in. This chapter explains the relationships that tie together 1 The cost of capital is an opportunity cost for the company’s investors, not a cash cost. See Chapter 4 for a more detailed explanation. 2 In its purest form, value is the sum of the present values of future expected cash flows—a point-in-time measure. Value creation is the change in value due to company performance (changes in growth and ROIC). Sometimes we refer to value and value creation based on explicit projections of future growth, ROIC, and cash flows. At other times, we use the market price of a company’s shares as a proxy for value, and total shareholder returns (share price appreciation plus dividends) as a proxy for value creation. 28  Fundamental Principles of Value Creation growth, ROIC, cash flows, and value, and it introduces the way managers can use these relationships to decide among different investments or strategies. For example, we will show that high-ROIC companies typically create more value by focusing on growth, while lower-ROIC companies create more value by increasing ROIC. We’ll also explore the principle, often forgotten by execu- tives, that anything that doesn’t increase cash flows, such as noncash account- ing charges or changes in accounting methods, won’t create value. And we’ll introduce a simple equation that captures the essence of valuation in practice. One might expect universal agreement on a notion as fundamental as value, but this isn’t the case: many executives, boards, and financial media still treat accounting earnings and value as one and the same and focus al- most obsessively on improving earnings. However, while earnings and cash flow are often correlated, earnings don’t tell the whole story of value creation. Focusing too much on earnings or earnings growth often leads companies to stray from a value-creating path. For example, earnings growth alone can’t explain why investors in dis- count retailer Costco, the fourth-largest retailer in the United States, with sales of $126 billion in 2017, and Brown-Forman, the producer of Jack Daniels and other alcoholic beverages, with sales of $4 billion the same year, earned similar shareholder returns (dividends plus appreciation in the share price) between 1996 and 2017. These two successful companies had very different growth rates. During the period, after-tax operating profits for Costco grew 11 percent per year, while those of Brown-Forman grew 7 percent annually. This means that profits for Costco in 2017 were nine times larger than in 1996, while profits at Brown-Forman were only four times larger. Costco was one of the fastest- growing companies in the United States during this time; its average annual shareholder returns were 15 percent. Brown-Forman was growing much more slowly, yet its annual shareholder returns were also 15 percent. The reason Brown-Forman could create the same value as Costco, despite much slower growth, was that Brown-Forman earned a 29 percent ROIC (excluding the impact of acquisitions), while Costco’s ROIC was 13 percent. To be fair, if all companies in an industry earned the same ROIC, then earn- ings growth would be the differentiating metric, because then only growth and EXHIBIT 3.1  Growth and ROIC Drive Value Cash flow Return on invested capital Revenue growth Value Cost of capital