Notes On The Relationship of Growth, ROIC, and Cash Flow

The purpose of any decision made by a company is to provide more value to the current and prospective shareholders. Companies create value for their shareholders by investing cash now to generate more cash in the future. The measure of value companies create is the difference between cash inflows and the cost of the investment made (adjusted to reflect that tomorrow's cash flows are worth less than today's because of the time value of money and the risk associated with future cash flows). The best way to measure the amount of value a company creates is through its return on invested capital (ROIC), revenue growth, and the ability to sustain both over time. The conversion of revenues into cash flows and earnings is a function of a company's ROIC and revenue growth, which is why these two are so important for measuring a company's value. When managers are trying to decide what strategy will help increase the company's value, they need to understand its relationship with growth, ROIC, cash flows, and value and how they all tie together. This introduces how the manager can use these relationships to decide among different investments or strategies. 

Close to every company needs to invest in plant, equipment, or working capital to grow. The only thing left for companies to invest with is the FCF leftover once investments have been subtracted from earnings. Growth, ROIC, and cash flow are tied together mathematically in the following relationship:  

Growth = ROIC x Investment Rate

Another way to look at this, in terms of cash flow, is:

Cash Flow = Earnings x (1-Investment Rate) 

The investment rate is equal to growth divided by ROIC. So, in other words:

Cash Flow = Earnings x (1 - Growth/ROIC) 

Since all three of these variables are bound together mathematically, you can present a company's performance with either one. Although, generally, a company's performance is presented in terms of growth and ROIC. Growth and ROIC are more feasible to analyze across time and against its peers. 

The picture below shows how different combinations of growth and ROIC generate different levels of cash flow that can be paid out to investors. The numbers in the boxes represent cash flow as a % of NOPAT (the profits available for distribution to investors). You can notice that as growth slows at any level of ROIC, the cash generated per dollar of NOPAT increases. This is a good explanation of why even maturing companies experiencing slow growth can pay out much more significant amounts of their earnings to investors. 

Important Note: Companies with high ROIC tend to generate a high amount of cash flow - as long as they are modestly growing. This is an excellent example of why mature tech and pharma companies with high returns on capital payout so much of their earnings to investors. This is because they really don't have any other options - they usually generate more cash flow than they need to reinvest at attractable returns on capital. 

If a company is growing at a constant rate and maintains a flourishing ROIC, you can reduce the discounted cash flow to a formula called the Value Driver Formula:

Value = NOPAT x 1 (1-G / ROIC) / (WACC - g)

This equation is an excellent way to see how value is driven by growth, ROIC, and the cost of capital. However, this formula should not be used by itself because it assumes endless growth and ROIC, but it is still useful to help visualize the elements that drive value. 

Important Note: Improving ROIC, for any level of growth, always increases value because it reduces the investment required for growth.