In Figure 1 below, we use our discounted cash flow framework to show how ROIC is the key valuation driver as measured by a Price to Earnings (P/E) multiple. The results from the 20 different Earnings Growth and ROIC scenarios show that a company must achieve ROIC greater than WACC (set to 10%) for growth to contribute to the value of a business. Growth has no impact on value of the business’ if ROIC is equal to its WACC. Growing a business that earns a ROIC below WACC increases the rate of value destruction.
When ROIC equals 10%, the same as WACC in Figure 1, the value of the business does not change no matter how much the company grows. This result stems from the fact that a business with ROIC equal to WACC neither creates nor destroys value. Growth from companies not earning ROIC above their WACC destroy value. The faster a business with ROIC less than WACC grows, the more value it destroys resulting in a lower, eventually negative, P/E multiple. Looking toward the right side of the chart reveals that a company with high revenue growth and ROIC above WACC can be very valuable.
P/Es and other multiples are the results of of value creation/destruction not a determinant.
Key Takeaway investors must understand that the economics of a business are more important than measuring a company’s growth.