Notes On Balancing ROIC and Growth to Create Value
Above is a matrix highlighting how different combinations of Growth and ROIC (return on invested capital) translate into value. Each cell represents the present value of future cash flows under each of the assumptions of Growth and ROIC, discounted at the company's cost of capital. If you look closely at any level of Growth, the value increases with improvements in ROIC. This is an excellent way to highlight why having a higher ROIC is always good.
A rising ROIC means that the company doesn't have to invest as much to achieve a given level of Growth. Unfortunately, the same can't be said for Growth. When ROIC is high, faster Growth will increase value - when ROIC is lower than the company's cost of capital, faster Growth will destroy value. This is the issue with many companies that are obsessed with Growth. When the company's ROIC is lower than the cost of capital - growing faster means the company’s investments could be destroying the company’s value (reiteration doesn’t hurt).
A good analogy for this would be trying to squat with pulled hamstrings. Instead of trying to repair and heal your hamstrings (ROIC), you instead keep adding weight to each squat (Growth), risking further injury. However, if your hamstrings are healthy and strong, then adding more weight to each squat can be beneficial to your strength development.
In the matrix above, you can also highlight how a company with high ROIC and low Growth may have a similar or higher valuation multiple than a company with higher Growth but low ROIC. This is because the company with a high ROIC has far more potential - they have proven to be efficient in allocating capital for a higher return in value. In the baseball world, we would say that the company with a high ROIC has a "high ceiling," which is a way to describe a ballplayer with a lot of potential and room for further development.
Important Note: Once in a while, you will hear an argument that even low-ROIC companies should strive for Growth (mainly from financial media or a hack with a business podcast). Their 'logic' behind this is that the companys ROIC will naturally increase if a company grows. However, that logic will only be found to be valid with young, start-up companies. With mature companies, a low ROIC indicates a flawed business model, or it's operating in an unattractive industry.
The narrative of “focusing on Growth will lead to scale” is a fugazi and a trap, both for managers and shareholders. A big part of it is that Growth is just easier for people to understand, which is why most managers and financial media focus on it so much. A lot of financial leadership and media have become more about storytelling and entertainment than delivering thorough and transparent analysis. So when you hear someone talking about growth, it would be to your benefit to see if the company is equipped to handle it - ROIC is a great metric for this.
Nutshell Summary:
Companies already earning a high ROIC can generate more added value by increasing their rate of Growth rather than their ROIC.
Low ROIC companies will generate relatively more value by improving their ROIC.
Therefore, if a company has a problem with ROIC, the company shouldn’t grow until the problem is fixed.