Question

Please explain why the following are value drivers in Finance/Corporate Finance:

1. Sales growth

2. Operating Profitability (OP = NOPAT/sales)

3. Capital Requirements (CR= operating capital/sales)

4. WACC (why is this a proxy for risk)

(I am having issues understanding why these are key value drivers in finance. Please explain their importance and how they value drivers.)

Answer 1

The value of any firm is a function of the cash flows, the growth of cash flows and the risk given by its discount rate. The discounted cash flow approach captures these factors required for valuation of a firm

1) Sales growth

Sales or revenue growth is the major growth driver as cash flow growth can be possible only if sales grow with every passing period. The free cash flow approach stresses on the importance of sales growth feeding higher cash flows which in turn feeds higher investment requirement again improving the cash flows through return on these investments.

2) Operating profitability (NOPAT/Sales)

NOPAT is EBIT*(1-t) or post tax operating profits. It is not enough for sales to grow because even though sales can grow, the costs can also grow compressing the margins or cash flows needed for higher valuation. Hence operating profitability is o prime importance and key value driver in improving the cash flows.

3) Capital requirements(operating capital/sales)

Operating capital is a key value driver as with increase in sales, there would be increase in working capital and operating capital requirements. This would mean higher cash flow into business as there would be less cash flows for firm to invest ffor long term. Thus capital requirements in a key value driver.

4) WACC

WACC or weighted cost of capital is the weighted average cost of debt and equity in the capital structure.The value for a firm emanates from the return on capital exceeding the WACC and better the margin of difference between the return on capital and WACC, better is the value for the firm. Higher WACC would mean a larger hurdle for the firm to return the cash flows and cover the cost of capital. This would entail higher risk and would be seen as higher WACC or risk for the cash flows.