Choosing the Levers of Value Creation

In my last blog, I discussed three ways in which incremental value is created in any business. In the accompanying video, I also discussed the drivers of value. ROIC, Revenue Growth, NOPLAT (Net Operating Profit Less Adj Taxes) and WACC (or Weighted Average Cost of Capital) are the factors that we can use to determine the financial figure for Value for a given business. 

If you notice carefully, NOPLAT in the expression for Value given below is for the first year. So NOPLAT and WACC here are pretty much constant values. Therefore the real levers we have to drive up the value of a business are ROIC and Revenue Growth.

 The question I want to address in this blog really is, which lever should we move? ROIC or Revenue Growth? Or both? It depends on the business you want to improve. It depends on the current ROIC and Revenue Growth of the business. 

Let’s get back to the expression for value. When I plot the “Value” against ROIC and Revenue Growth in a simple chart, this is what I get...

I have taken NOPLAT as 100 and WACC (Cost of Capital) as 10% to plot this chart. Notice that there are two zones in the chart, one on either side of the vertical line drawn at 10% ROIC. When ROIC is less than WACC, which we have assumed to be 10%, then Value decreases with higher revenue growth. What it really means is that a business must have its ROIC greater than WACC. Otherwise there is no point in investing the capital because a business with an ROIC less than WACC is simply not viable.

But the real use of this simple fact is lies in a more granular analysis of a company. While most businesses have an ROIC that is well above the WACC, there will be some individual business units within a larger business, or even individual product lines or service offerings, that will have their specific ROIC values lesser than WACC, and get unnoticed unless this sort of analysis is performed at a granular level. Such business units and product lines drain the value rather than creating it. 

For the business units and product lines with ROIC values that are marginally higher than WACC, you can see from the chart that the incremental value created by increasing revenue growth is very limited, but increasing ROIC has much greater effect. Whereas for business units and product lines that already have a higher ROIC, increasing the revenue growth rate will result in a rapid creation of value.