Question

Part (a) "Companies create value for their owners by investing cash now to generate more cash in the future. The amount of value created is the difference between investments made and cash inflows -- adjusted for the fact that tomorrow's cash flows are worth less than today's, due to the time value of money and riskiness of future flows. As demonstrated later, a company's return on invested capital (ROIC)*, and its revenue growth, determine how revenues get converted into cash flows. Therefore, value creation is ultimately driven by ROIC, revenue growth and, of course, the ability to sustain both over time. Return on invested capital Cash flow Revenue growth alue Cost of capital (a) Based on the information above, explain (in no more than 80 words) the meaning of "value creation" (5 marks) (b) Based on the four factors stated in the exhibit above (ROIC, Revenue growth, Cash flow and cost of capital), explain under what conditions will 1) value be created? 2) value neither/nor be created? 3) value be destroyed? Hint: Draw on the materials covered in Investment Decision Rules (Ch.12)] (ch.12) (io marks) (c) "A prerequisite for managing a listed company is understanding how the stock market works. By understanding the market better, executives can have more confidence that their decisions will both create value and be reflected in the price of their shares. Based on the above paragraph, briefly explain the following statement: "The firm (the investor interested in investing in) is good but the investment is bad!" (5 marks)

Answer 1

(a)Value of creation based on above information

based on above information value of creation mean  this means creating revenue which exceeds expenses which results in a profit, or value, to the stakeholders. A broader definition includes creating value for the customer to increase sales, and to create perceived value in the company brand.

Enhancing customer value by improving the quality of products or services in a matter which induces customers to pay more than they firms costs of improvement is key to the process of value creation.

Value creation is the primary aim of any business entity. Creating value for customers helps sell products and services, while creating value for shareholders, in the form of increases in stock price, insures the future availability of investment capital to fund operations.

(b) ROIC , revenue growth , cash flow and cost of capital under condition will value be create

High returns on invested capital come from one of two sources; 1) Large amounts of revenue generated for each dollar of invested capital, known as high “turns” of invested capital and/or 2) high levels of after-tax profits generated per dollar of revenue, known as high-profit margins. Turns x margin = ROIC (this is a rearrangement of the formula for ROIC we presented HERE). In order to generate high ROIC, a company must either have very high profit margins or need low levels of invested capital (ie. be “asset light”) or a combination of the two.

Because profit margins are bounded (pre-tax profit margins can’t exceed 100% and all companies pay some tax) it is difficult for a company to generate outstanding ROIC simply through a high profit margin. The far more common path is for a company to craft a business model that does not require them to invest too much new capital in order to grow. These asset-light companies are very prevalent in Ensemble Capital’s portfolio.

ROIC , revenue growth , cash flow and cost of capital under condition will value be destroyed

One downside of this metric is that it tells nothing about what segment of the business is generating value. If you make your calculation based on net income (minus dividends) instead of NOPAT, the result can be even more opaque, since it is possible that the return derives from a single, non-recurring event.

ROIC provides the necessary context for other metrics such as the P/E ratio. Viewed in isolation, the P/E ratio might suggest a company is oversold, but the decline could be due to the fact that the company is no longer generating value for shareholders at the same rate—or at all. On the other hand, companies that consistently generate high rates of return on invested capital probably deserve to trade at a premium to other stocks, even if their P/E ratios seem prohibitively high.