Chapter 2- Fundamental principles of value creation
Question 1- What was the reason the fast growing company Walgreen and the significantly slower growing company Wrigley, Between 1968 and 2007 had nearly the same shareholder return?
For example, earnings growth alone can’t explain why investors in drugstore chain Walgreens, with sales of $54 billion in 2007, and global chewinggum maker Wm. Wrigley Jr. Company, with sales of $5 billion the same year, earned similar shareholder returns between 1968 and 2007.3 These two successful companies had very different growth rates. During the period, the net income of Walgreens grew at 14 percent per year, while Wrigley’s net income grew at 10 percent per year. Even though Walgreens was one of the fastest-growing companies in the United States during this time, its average annual shareholder returns were 16 percent, compared with 17 percent for the significantly slower-growing Wrigley.
The reason Wrigley could create slightly more value than Walgreens despite 40 percent slower growth was that it earned a 28 percent ROIC, while the ROIC for Walgreens was 14 percent (a good rate for a retailer). To be fair, if all companies in an industry earned the same ROIC, then earnings growth would be the differentiating metric. For reasons of simplicity, analysts and academics have sometimes made this assumption, but as Chapter 4 will demonstrate, returns on invested capital can vary considerably, even between companies within the same industry.
Value Inc. generates higher cash flows because it doesn’t have to invest as much as Volume Inc., thanks to its higher rate of ROIC. In this case, Value Inc. invested $25 million (out of $100 million earned) in year 1 to increase its revenues and profits by $5 million in year 2. Its return on new capital is 20 percent ($5 million of additional profits divided by $25 million of investment).4 In contrast, Volume Inc.’s return on invested capital is 10 percent ($5 million in additional profits in year 2 divided by an investment of $50 million).
Question 3 – Describe how growth, return on invested capital (ROIC) and the investment rate are tied mathematically.
Growth, ROIC, and cash flow (as represented by the investment rate) are tied together mathematically in the following relationship:
Investment Rate = Growth ÷ Return on Invested Capital
The growth will actually destroy value if WACC > ROIC
Observe that for any level of growth, value increases with improvements in ROIC. In other words, when all else is equal, a higher ROIC is always good
Question 6 – Assume a company has a cost of capital that is equal to the achieved ROIC. What will happen to the value of the company if the growth increases
When ROIC is high, faster growth increases value, but when ROIC is lower than the company’s cost of capital, faster growth necessarily destroys value, making the point where ROIC equals the cost of capital the dividing line between creating and destroying value through growth. On the line, value is neither created nor destroyed, regardless of how fast the company grows
Question 7 – What are the conclusions regarding growth strategies based on organic growth, Compared to acquisitions. Which strategy normally has the highest return and why?
Growth strategies based on organic new product development frequently have the highest returns because they don’t require much new capital; companies can add new products to their existing factory lines and distribution systems. Furthermore, the investments to produce new products are not all required at once. If preliminary results are not promising, future investments can be scaled back or canceled.
Acquisitions, by contrast, require that the entire investment be made up front. The amount of up-front payment reflects the expected cash flows from the target plus a premium to stave off other bidders. So even if the buyer can improve the target enough...
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