- August 30, 2020
- Posted by: Ramkumar
- Category: Strategy
Importance of ROIC in Business Valuations
Businesses generate value for their stakeholders by investing cash now to generate more cash in the future. The measure of the value they create is the difference between cash inflows and the cost of the investments made, adjusted to indicate the reality that future cash flows are worth less than current due to the time value of money. That suggests the amount of value a company generates is governed conclusively by its ROIC, revenue growth, and capacity to maintain both over time. A business will create value only if its ROIC is more significant than its WACC. Therefore it is crucial to every strategic and investment decision to recognize and predict what drives and maintains ROIC. In this post, I provide my insights on importance of ROIC in business valuations.
The consequence of ROIC is accepted: it pertains to corporations as well as to businesses within organizations. For instance, Amazon generates stable revenues from third-party sellers within its retail business model using its online platform. Platform sales by third parties produce increasing returns to scale, more so than Amazon’s direct sales. Platform sales need little invested capital, and Amazon’s marginal cost of added transactions is minimum. As a consequence, platform sales have become an essential driver of Amazon’s overall value creation.
What Drives ROIC?
To understand the importance of ROIC in business valuations, we need to understand how strategy, competitive advantage, and return on invested capital are linked, consider the following representation of ROIC:
ROIC = (1-Tax Rate) (Price/Unit – Cost/Unit)
To obtain a higher ROIC, a firm requires a competitive advantage that permits it to charge a price premium or offer its products more efficiently (at a cheaper cost). A company’s competitive advantage depends on its adopted strategy and the industry in which it serves.
According to Porter, the strength of competition in an industry gets defined by five forces: the threat of new entrants, the demand for substitute products, the bargaining power of buyers, that of suppliers, and the measure of rivalry amidst surviving competitors. Companies need to adopt strategies that develop competitive advantages to alleviate or change these pressure and deliver better profitability. The five forces vary by industry, and because companies in the related industry can pursue distinct strategies, there can be notable variations in ROIC across and within industries. However, industry structure and competitive behavior change due to technological innovation, shifts in government regulation, and competitive entry, influencing particular companies or the whole industry.
Importance of ROIC in Business Valuations – Competitive Advantage
Competitive advantage stems from commanding a price premium, improving cost and capital efficiency, and applying network effects that connect price and cost advantages to deliver increasing returns to scale.
Price premiums allow companies the most significant scope for producing an attractive ROIC, but they are usually more challenging to accomplish than cost efficiencies. Furthermore, the businesses generating the highest returns usually mesh collectively with more than one advantage.
Price Premium Advantages to improve ROIC in Business Valuations
Five sources of price premiums are innovative products, quality, brand, customer lock-in, and price efficiency.
Innovative goods and services generate high capital returns if they get guarded by patents or challenging to copy. Pharmaceutical companies get high returns because they offer innovative products that are usually easy to copy but are defended by patents for up to 20 years.
An instance of an innovative product line that is not patent protected but still challenging to imitate was Apple’s series of iPod MP3 players. MP3 players had been on the market before Apple launched the iPod, and the core technology was identical for all competitors. Still, the iPod was successful because of its appealing design and ease of use provided by its user interface and integration with iTunes. Apple pursued a similar approach with the iPhone and iPad; once again, the design and user interface were core drivers of the price premium. Although not patent-protected, good design can be challenging to replicate.
Quality & Brand
Price premiums based on the brand are seldom difficult to distinguish from price premiums based on quality, and the two are positively related. While the quality of a product may weigh more than its entrenched branding, sometimes the brand itself is what means more—particularly when the brand has endured a very long time, as in Heineken, Coca-Cola, and Mercedes-Benz.
Packaged food, beverages, and durable consumer goods are great representatives of sectors where brands get price premiums for some but not all products. Because of their strong brands, beverage and cereal companies can realize returns ~30% ROIC compared to processed foods.
When substituting one company’s product or service with another’s is comparatively costly for customers, the incumbent business can charge a price premium—if not for the first sale, then at least for added units or upgrades of the original product. High switching costs, compared to the product price, constitute the strongest customer lock-in. Like artificial joints, medical devices can lock in the doctors who buy them because doctors require time to train and become skilled in exercising and implanting those devices. Once doctors are up to speed on a device, they won’t change to a competing product unless there is a compelling incentive to invest the significant effort.
Importance of ROIC in Business Valuations – Cost and Capital Efficiency Advantages
Cost and capital efficiency are two distinct competitive advantages. Cost efficiency is the capability to produce products and services at a more economical cost than the competition. Capital efficiency is about producing more products per dollar of invested capital than competitors. In tradition, both tend to share standard drivers and are difficult to insulate.
Scalable products imply that the cost of serving added customers is meager at almost any scale level. Businesses with this advantage typically produce their products and services employing information technology (IT). Consider a company that produces standardized software that needs minimum customization. Once the software gets developed, it gets sold to various customers with no incremental development costs. So the gross margin on incremental sales could be ~100%. As sales soar, the only costs that rise are for selling, marketing, and administration. New players like PayPal have achieved leading positions in financial and payment services by starting new business models developed on innovative technology platforms. Incumbent players, strapped with heritage organizations, systems, and processes, have found it hard to imitate the innovations.
Most IT-based or IT-enabled businesses offer scalability, especially given recent progress in cloud-based computing. However, what counts is whether all crucial elements of a business system are scalable. Take, for instance, online food delivery businesses. These businesses can quickly scale up in terms of the number of registered restaurants, customers, and orders. However, they still acquire incremental costs for every order delivery, if just for transportation.
Importance of ROIC in Business Valuations – Network Economies
Some scalable business models give unusually high returns on capital because they display network effects that point to growing returns to scale. As the business earns customers and expands, the cost of offering the products drops, and their value to customers rises.
The competitive advantage becomes even more potent when customers encounter high switching costs. Consider a business like Microsoft. Its Office software benefits from scalable operations on the cost side because it can provide online products and services at a low marginal cost. The office has also become more valuable as the customer base has increased over time. Microsoft has been able to lock in customers who want to exchange documents with other Office users easily and are not interested in spending time and effort switching to alternative software. Some social-media business models, such as Facebook’s, allow similar customer lock-in combined with increasing returns on the scale.
Although several new digital business models for social media, digital marketplaces, and e-commerce like to insist on such increasing returns to scale, they only happen in exceptional circumstances. For instance, many U.S. electric-power producers tried to get big quick by buying up everything they could. Most failed because there are no increasing returns from scaling electric-power production. Maybe more significant, such scale effects lead to superior lasting returns only if a company can deter competitors from realizing a similar scale.
The valuation of a business depends on growth and returns on invested capital. ROIC gets driven by competitive advantages that allow companies to accomplish price premiums, cost, capital efficiencies. Assume a firm with a differentiating competitive advantage earns an attractive ROIC. In that situation, there is a great chance it can maintain that attractive return over time and through varying economic, industry, and company conditions, particularly in industries that experience relatively long product life cycles. Of course, the reverse also is true: if a company earns a low ROIC, that is likely to continue as well.