ROIC linked to business growth !
ROIC linked to growth !
Author: Joris Kersten MSc / Owner Kersten Corporate Finance
Kersten Corporate Finance: Buy side and sell side M&A in The Netherlands (deals: 5 – 50 million euro enterprise value) + Business Valuations + Corporate Finance training over the globe.
Source used: Morgan Stanley Investment Management: Counterpoint Global Insights/ Return on Invested Capital/ How to calculate ROIC and handle common issues. October 2022. M.J. Mauboussin, D. Callahan.
Introduction
At the 15th of June 2023 I wrote the first article in this blog series on ROIC:
Analysing ROIC (return on invested capital):
You can find it on the link above in case you have not read it yet.
In this blog I will continue with the subject ROIC.
Investments in growth
The value of a company can be calculated by projecting the free cash flows (FCF) and discounting it back to the present.
And FCF equals NOPAT -/- the investments for future growth.
Investments in future growth capture:
-Changes in net working capital;
-Capital expenditures net of depreciation;
-Other investments like acquisitions.
So investments in future growth are equivalent to the change in IC (invested capital).
Link to a DCF model
The observations above give us a nice link to a DCF model.
When you have estimated your initial IC, and your DCF model is estimating future NOPAT, and additional investments ( capex net of depreciation + net working capital ), than you can easily calculate ROIC in any future year.
This by taking future NOPAT and dividing it by future IC, both will be created by your DCF model.
For example, a company has a NOPAT of 100 USD, and IC of 500 USD, than ROIC is 20%.
With 10% NOPAT growth, your NOPAT in 2 years is 100 USD * 1,10 ^ 2 = 121 USD.
When you assume investments (capex net of depreciation + NWC) are 25 USD per year, than ROIC in 2 years is:
121 / ( 500 + 25 + 25 ) = 22%.
ROIC linked to valuation
ROIC is linked to valuation by “economic profit”.
This is a measure of “residual income”, and this means income after all costs have been taken into account, even including the cost of capital !!!
The cost of capital is the same as WACC ( weighted average cost of capital ).
Economic profit can be calculated in 2 ways ( with similar outcomes ):
-Economic profit = ( ROIC -/- WACC ) * invested capital;
-Economic profit = NOPAT -/- ( invested capital * WACC ).
ROIC linked to growth
ROIC is also linked to growth.
This because ROIC is the maximum supportable growth rate of a company WITHOUT external financing !
Let’s take a look at this with a simple numerical example, but first let’s look at a formula:
-Growth = ROIC * ( 1 -/- payout ratio ).
The payout ratio is the part of NOPAT a company pays out to its shareholders in the form of dividends and share buybacks.
And of course, this leaves less money available to reinvest.
With 100 USD NOPAT, and IC of 500 USD, ROIC was 20%.
Without any payout, the 100 NOPAT makes again: 20% * 100 = 20 USD (additional NOPAT).
In total: 500 IC + 100 IC ( from nopat ) = 600 IC.
600 IC * 20% ROIC = 120 NOPAT ( 100 + 20 ).
And another year later:
720 IC ( 600 + 120 ) * 20% ROIC = 144 USD NOPAT ( 100 * 1,20 ^ 2 )
Growth rates higher/ lower than ROIC
Companies with a growth rate lower than ROIC will be able to payout cash without compromising on growth.
For example, if the company of the example only grows with 10%, than it can pay out 50 USD of NOPAT.
100 NOPAT / 500 IC = 20% ROIC
When growth is 10%:
NOPAT * ( 1 + 10% ) = 110 NOPAT
110 / 20 * 100 = 550 IC is needed.
So 50 can be paid out: 100 nopat + 500 IC -/- 50 pay out = 550 IC needed
On the other hand, companies with growth above ROIC need additional financing.
With a growth of 2 times ROIC, NOPAT grows with 40%.
100 nopat * ( 1 + 40% ) = 140 nopat
140 / 20 * 100 = 700 IC needed.
700 IC needed -/- 500 IC -/- 100 NOPAT = 100 IC ( additional capital needed )
But of course, a ROIC of 20% is likely above WACC, so getting 100 new IC most likely creates lots of value in this example !!
I hope you found this blog useful !
See you next week again with a new blog on valuation and/ or M&A !
Have a nice weekend, best Joris
Source used: Morgan Stanley Investment Management: Counterpoint Global Insights/ Return on Invested Capital/ How to calculate ROIC and handle common issues. October 2022. M.J. Mauboussin, D. Callahan.