Companies create value for their owners by investing cash now to generate more cash in the future. The amount of value they create is the difference between cash inflows and the cost of the investments made, adjusted to reflect the fact that tomorrow’s cash flows are worth less than today’s because of the time value of money and the riskiness of future cash flows. As we will demonstrate, a company’s return on invested capital (ROIC) and its revenue growth together determine how revenues are converted to cash flows (and earnings).
That means the amount of value a company creates is governed ultimately by its ROIC, revenue growth, and ability to sustain both over time. Keep in mind one important caveat: a company will create value only if its ROIC is greater than its cost of capital (the opportunity cost for its investors). Moreover, only if ROIC exceeds cost of capital will growth increase a company’s value. Growth at lower returns actually reduces a company’s value.
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