Question

Comprehensively explain, using numerical examples, how, as a corollary to Fact 1, value is created by companies, for shareholders, when companies generate higher cash flows, not when rearranging investors' claims on those cash flows.

Answer 1

Value is created when companies invest their capital to generate future cash flows at rates of return that exceeds the cost of capita. In other words when a company invests its capital and amount raised from investors and other providers of capital in such a manner that the rate of return from these investments exceeds the cost of capital then value is created for the shareholders of that company. Thus the faster that a company is able to grow its revenue and put in or invest their capital at attractive rate of return the faster and the larger quantum of value will be created. In other words value is dependent on growth and return to a large extent.

It should be noted that rearranging investor’s claim on those cash flows will not create value as no conservation of capital is happening when the investor’s claims are rearranged. So even if a company changes equity for debt or changes debt for equity it will merely change the ownership of claims to its cash flows. It will, however, not change the amount of total available cash flow or the amount of added value in any manner.

For numerical example suppose that a company’s ROIC is just 5% and another company (which is its competitor) has a ROIC of 15%. Note that ROIC = Net operating profit after tax/Total invested capital. For the 1^st company value will be created by improvement in the ROIC. Thus for the 1^st company it has to improve its ROIC beyond 5% to create incremental value. For the 2^nd company ROIC is high and thus it can create value by garnering improvements in its growth. This is because intrinsic value = (NOPAT*(1-(g/ROIC)))/(w-g)