Importance of Return on Incremental Invested Capital

I want to highlight a key premise from “Multiples Paper” by Michael Mauboussin which talks about the core concept of how to run a business or what to look for when investing in a business. And this might not apply at all time for all types of businesses especially when they are in initial growth phases. But its a good factor to have in your checklist as an Investor. By the by this paper is a must read. You can find the complete paper at –>

https://www.valuewalk.com/wp-content/uploads/2014/02/document-805915460.pdf

Key tenet I took away from this paper:

When companies and investors think about valuation, they commonly start with growth. But an understanding of the first two drivers of value shows why this focus is wrong. If a company is expected to have an ROIIC exactly equal to the cost of capital, the second term of the equation collapses to zero and the price-earnings multiple goes to the steady-state level. If ROIIC is above the cost of capital, the second term is positive, and growth will enhance value. Finally, if ROIIC is less than the cost of capital, growth destroys shareholder value. More rapid growth leads to greater value destruction.

So whether growth is virtuous depends on the firm’s incremental economic returns. A company can grow its earnings per share without creating shareholder value. In their view, proper thinking about valuation requires dwelling first on the incremental return on investment and only later considering the impact of growth.

If a company is generating returns in excess of the cost of capital, growth is good. Indeed, all things being equal, faster growth translates directly into a higher price-earnings multiple.

Above passage is the holy grail of Investing framework.

 

 

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