Review Questions Company Valuation
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.
Question 2
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
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.
Question 2
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