key value drivers - bfa.docx

Key Value Drivers In this module, we're going to talk about the key value drivers related to value creation. At a high level, there's a lot of math associated with value creation, but it really boils down to three major things. Number one, what's your spread? Number two, what's your growth? Number t...

Key Value Drivers In this module, we're going to talk about the key value drivers related to value creation. At a high level, there's a lot of math associated with value creation, but it really boils down to three major things. Number one, what's your spread? Number two, what's your growth? Number three, how sustainable is your spread and your growth? That's what matters to the math and that's what matters to investors. So let's go through each one. The first value driver is around spread. It's the difference between your ROIC, what you earn and what you're expected to earn for the risk you take what's called the cost of capital or the weighted average cost of capital, often called your WACC. You only create value when you have a positive spread. I go to a bank, I get a loan, they give me money at 9% annually. I then take that money, I put it to work, I make 5% - I can't create value. The more I do, the worse off I am. As a matter of fact, the opposite is true. If I borrow at 9% and I make 15%, I create a lot of value. So that's the idea, is that investors are going to look at what they think your returns are going to be over time, and they're going to look at what risk you take and what you need to make in those returns, and that's going to be called the spread of the business. Over time, to create value, you have to have a positive spread. If you don't, don't pass go, don't collect $200. The second driver is Growth. Growth does not create value. I'm going to say that one again because it sounds controversial because it's not what you think. Growth doesn't create value. Let's go back to the first example. If you borrow at 9% and you make 5%, do you want to do more of that? The more you grow that, the worse off you are. So growth is the accelerant to value. It's like throwing gasoline on a fire. And so, if you have a positive spread, borrow at 9% and make 15%, the more you grow, the more exponentially you create value. If you borrow at 9% and you make 5%, the more you grow, the worse off you are. What investors focus on is the growth/spread combination, the growth/return combination. That's what's going to matter to the math. That's what's going to matter to value creation. The third driver is what's known as sustainability. How long can you maintain that return and spread? How long can you maintain that growth rate? Nothing last forever. So an ideal investment has all three. Find me an opportunity where I can get a positive spread, find me an opportunity where I can grow that spread consistently and find me an opportunity that is sustainable against competition for a period of time. When I have those three things, that's when I've really created value for a business. Now let me go back and talk a little bit more about the concept of spread, because the real key driver that we control as leaders is our ability to influence Return on Invested Capital (ROIC). And ROIC is a function of two things, how much or how profitable you are, how much you make, and how often or how productivity drives business, how efficiency drives the business, or how often you make that profit. Those are the two things that drive ROIC. So let me give you a quick example. Two businesses have identical profit margins, we'll call them A and B, they both make $0.08 cents per year, 8% margins selling their sales to their customers. But, business A takes 267 days to make the $0.08 and business B takes 135 days to make the $0.8. That's what's known as the financial cycle time. So the business model for business A is when they sell their product or service, they make 8% every 267 days, business B makes 8% every 135 days. Which of the businesses do you think is going to be more valuable? Obviously it's going to be business B. Because here's the point, on an annualized basis, $0.8 every 267 days works out to $0.11 a year, $0.8 every 135 days works out to $0.22 cents a year. Business B is going to be more valuable, not because they're more profitable, but because they make it more often and they're more efficient at what they do. That annualized profit number, that percent is called ROIC and that's why they become key value drivers for the business because ROIC is a proxy for how much cash you'll generate on an annualized basis. And there's going to be two things that are going to drive your ROIC, your margins, how much and the how long, which is your productivity and your efficiency. So let me give you a real world example. Think about the two companies Merck and Costco. Merck is a major pharmaceutical company that makes much higher profit margins when it sells a drug then Costco the discount retailer when it sells its retail products out of a warehouse. The difference between the companies is in the productivity or the how often they sell the products. Merck takes much longer to sell its products to earn its high margin. Costco earns lower margins but makes them more frequently. When we annualize the data – Costco makes the higher ROIC and generates more cash profit per dollar of investment than Merck. When evaluating the key value drivers of a company there are ultimately 5 drivers that will impact value. The first is the company's profit margin or how much it makes when it sells a product. The second is a company's productivity or efficiency which represents how much it spends to make the sale or how often a company sells its product. The third driver is the risk which is known as the cost of capital or the whack. The 4th driver is the rate of growth. And the 5th driver is the sustainability of the company's advantage. These represent the key value drivers of a company and are the levers that can be pulled to drive value.