Why Customer Success Needs Financial Smarts

"Value creation" has become a ubiquitous phrase that resonates in virtually every company meeting, yet few managers & executives truly understand what "value" is or how it's measured. This article endeavors to demystify the concept of "value" & emphasize why leaders & executives especially those with non-financial backgrounds need to understand where true value comes from, how to create it & perhaps more importantly how not to destroy it.

If managers & leaders clearly understand the core principles of value creation, they can take better decisions & make tough calls with greater clarity & confidence.

The Core Value Principle

How do companies create value? Value Creation is at the core of all business decisions. Do firms create real value by growing revenue or by growing earnings (profit)? What are the parameters & metrics one needs to keep an eye on to know whether or not your firm or your own department is creating value?

Actual value is created by the cash flows a firm generates. Firms create value by investing capital to generate future cash flows. Those cash flows are determined by the following two factors:

• How fast the company can grow its revenue.
• The return the firm earns on the capital that it invests-Return on Invested Capital (ROIC) or Return on Capital (ROC)

It’s this combination of?Revenue Growth?and?Return on Invested Capital?(ROIC) that drives cash flows which in turn drives the "value" of the firm. In Corporate Finance this is known as "The Core Valuation Principle".

Let’s explore why Return on Invested Capital (ROIC) & Revenue Growth drive the cash flows & thus the value of the company. It may seem a bit surprising that we’ve not included earnings or profit in this. It's not that earnings are not important, but it’s perfectly reasonable to see two companies with similar earnings and similar earnings growth generating very different amounts of cash flows & ultimately different values.

The reason is that they generate different Return on Invested Capital (ROIC). It's the ROIC that translates revenue & earnings into cash flows. So, ultimately what matters is revenue growth & ROIC which in turn drives earnings & cash flows and therefore value. Let’s see how this simple chart below mimics the value of real companies:

The chart is based on a 9% CoC (Cost of Capital), a typical large firm in the US or Europe has a Cost of Capital of about 9%. Also, historically in US & Europe a typical large firm has a Return on Invested Capital (ROIC) of about 13% & a Revenue Growth rate of about 4-5%.

If we look at the intersection of 13% ROIC & 4-5% growth, you will see we end up with a company that is valued at 1500-1600. We’ve assumed this company starts with earnings of $100. So, if we divide the $100 with the value of the firm we end up with an implied?P/E Ratio of 15-16 times.?Coincidentally, the P/E ratio of large companies in the USA or Europe is about 15-16 times?when inflation & interest rates are at reasonable levels.

This simple model does a good job of mimicking the way the real world works.?Now, let’s explore how changes in ROIC & Revenue Growth affect the value of the firm.

We'll first explore the impact of ROIC on a firm's value. As we go from left to right for any level of growth the ROIC increases & so does the value of the firm.?This means for the same level of growth improving the Return on Invested Capital (ROIC) always creates value, so a higher ROIC is always better.?As we will see below, the same, however, cannot be said for revenue growth!

Can growth ever destroy value for a company?

Let’s look at how growth affects the value of a firm. Most managers & even senior executives believe that a higher rate of growth is always good for their firm. If you are one such believer, the example below will surprise you.

The Cost of Capital for this firm is @ 9%. If we look at the right-hand side of the chart (green column), the firm earns 25% ROIC, as the firm grows faster from the bottom to the top, we see that the value of the firm increases. So, higher growth @ 25% ROIC definitely increases the value of the firm from $1,600 to $2,500.

Now, let's look at the left-hand side, when the firm earns 7% ROIC. Note that the Cost of Capital which the firm has to pay to its debtors is 9%. Now, what happens when a firm with 7% ROIC grows faster? As we go from bottom to top from a slower rate of growth @ 3% to a higher rate of growth @ 9% the value of the firm actually declines, Why?

With a higher rate of growth, the value of the firm declines because as the firm is growing, it is investing more capital @ 7% return whereas it has to pay a 9% return. So, as the firm grows faster, the more value it destroys & the value of the business declines. Below the 9% Return on Invested Capital, the value of the company actually decreases as the company grows faster!! ?

Let’s look at the 2nd column – here the firm earns a 9% Return on Invested Capital (ROIC), which is exactly equal to the Cost of Capital (COC).

When the Return on Capital = Cost of Capital, even if the firm grows faster from 3% to 9% or more, the value of the firm does not change at all, it stays the same!

This is because in this situation the growth of the firm neither creates nor destroys value. At this rate, the firm is simply earning its Cost of Capital.?It’s like the firm is on a treadmill, it gets sweaty, but in the end, when it's done, it's exactly where it started.

Tale of 2 Firms: Same Earnings & Growth Rate, Different Cash Flow

Let's consider 2 firms A & B whose projected earnings (NOPAT), investment, & CF are displayed below. Both firms earned NOPAT of $100 Mil in year1 and increase their revenue & earnings at 5% per annum; so their projected earnings (NOPAT) are identical. But as we will see their values are very different.

All firms need to invest in plants or Sales & Marketing or in working capital to grow. Free Cash Flow (FCF) is what's left over for investors once investments are subtracted from earnings. Firm A generates higher FCF with same earnings as it invests only 25% of its earnings to achieve the same earnings (profit) growth as Firm B, which invests 50% of its earnings.

Firm A's lower investment rate results in 50% higher FCF each year than Firm B while generating same leve of earnings. We can value the 2 firms by discounting their future CF at a discount rate that is their Cost of Capital (say 10%). The Table below display's each firms Value.

Firm A generates higher cash flow with the same earnings because it invests only 25% of its earnings to achieve the same growth rate as Firm B which invests 50% of its earnings or profits. Firm A's lower investment rate results in 50% higher Free Cash Flow (FCF) each year. When we sum each year's results to calculate the Net Present Value (NPV) we get $1,500 Mil for Firm A & $1,000 Mil for Firm B.

Challenges for Low ROIC Companies:

A common belief is that ROIC will typically increase when a firm grows faster. Data shows that this is usually not the case for larger companies. Very small companies, startups in particular when they scale & grow faster their margins increase as they are able to generate economies of scale and spread their cost over a larger base. But for most larger firms?a low ROIC indicates a deeper problem that needs to be fixed before the firm should focus on growth. Some of the most common reasons for poor ROIC are:

• High-cost structure of the company
• Firms' products are not "distinctive enough" to demand premium pricing.

In such situations, the leadership needs to fix these issues to improve ROIC before they turn their focus on revenue growth.?Where your business stands in terms of ROC & growth has important implications for strategy particularly its choice of whether to focus on ROC or Revenue Growth.

Implications for Customer Success

As we see in the above example, it's becoming increasingly crucial for leaders & managers to possess a sound understanding of key financial principles. As in its absence executives & managers can inadvertently destroy value in pursuit of growth. Many sections of our economy have moved away from one-off payments to a Recurring Revenue Model. This transition has brought functions like Customer Success (CS) central stage in pursuit of aggressive growth targets. Hence, leaders in CS need a firm grasp of many key financial principles & metrics so that they can meaningfully contribute towards their firms' higher valuation.