Fundamentals of Value Creation: Understanding Spread and Key Value Drivers

Value creation is a vital concept in the world of finance and investment. It refers to the process of generating economic value for stakeholders, such as shareholders, employees, and customers. In this article, we will delve into the concept of spread and its role in value creation, as well as the key value driver framework.

Spread: The Core of Value Creation

Spread is the difference between the return on invested capital (ROIC) and the cost of capital. Value is only created when the ROIC is greater than the cost of capital. This principle is applicable to both individuals and corporations. For example, borrowing money at 6% to invest in a venture that yields 4% would result in value destruction, as the cost of capital is higher than the return on investment.

In the corporate world, the funds provided by investors to a company are referred to as invested capital or capital employed. The cost of capital represents the annualized rate of return required to compensate investors for the risk they are taking. The return on invested capital (ROIC) is the profit generated from the capital employed.

Economic Value Added (EVA) and Economic Profit

Economic value added (EVA) is a dollar-based framework used to assess whether a company is creating or destroying value during a specific period. It is calculated by subtracting the capital charge (cost of capital multiplied by invested capital) from the profit generated by the investment. The term "economic profit" is often used interchangeably with EVA. The formula to calculate EVA or Economic Profit is as follows:

EVA (Economic Value Added) = NOPAT - (Capital Charge)

Valuing a Business: The Growing Perpetuity Formula

When valuing a business, the growing perpetuity formula is commonly used to determine the continuing or long-term value of a business. This formula assumes that a company will last forever and generates constant cash flows that grow at a constant rate. However, the formula has its limitations, as it exaggerates the directionality of the performance of a business and does not provide an accurate view of its long-term value.

Value = Cash Flow / Cost of Capital - Growth

The Key Value Driver Formula

To address the limitations of the growing perpetuity formula, consulting firm McKinsey developed the key value driver formula. This formula rearranges the math and focuses on profit and return on invested capital rather than cash flow. The key value driver formula is as follows:

Value = Profit × (1 - Reinvestment Rate) / Cost of Capital - Growth

Here

Growth = Reinvestment Rate × ROIC

So, Reinvestment Rate = Growth /ROIC

Value = Profit × (1- Growth/ROIC)/Cost of Capital - Growth

The Key Value Driver Formula and Value Tree analysis serve as essential tools for consulting companies to help their clients optimize costs, identify growth opportunities, and enhance overall performance.

This article has provided an overview of the Key Value Driver Formula. In the next article, we will dive deeper into the concept of Industry Value Driver Tree analysis. By examining these industry-specific factors, companies can gain insights into their competitive landscape, identify trends and challenges, and uncover unique opportunities to differentiate themselves and drive growth. Stay tuned for a comprehensive exploration of Industry Value Driver Tree analysis and its practical applications.