(0:04) To build a valuable business, if you focus on increasing your return on invested capital while ensuring it stays above your cost of capital, then you can optimize your return on invested capital, which is the key to long-term value creation.

(0:09) Welcome to Business Strategy, where we are documenting the best strategies and valuable lessons learned to build more profitable and iconic companies. Please share and enjoy.

(0:15) Let's talk about one of my favorite topics, which is strategy plus finance equals value creation. Now, I know I just said a bunch of jargon, but quite simply, what we're talking about here is when it comes to business strategy, it's not about slapping mission, vision, and values up on the wall, doing a SWOT analysis, and going through these exercises where you're trying to define what your future looks like without bringing it back to economic reality.

(0:40) And I'm also not referring to creating these extensive spreadsheets where you're basically just modeling out whatever the CEO says, right, where the CEO's like, yeah, we're going to grow by 20%, and you build out a financial model that shows 20% top-line growth.

(1:02) Because remember, who owns revenue? Your customers. You only control your cost and your profit. So, what I'm saying here is that at the end of the day, value creation comes from combining strategy and finance together.

(1:20) Now, let me explain what I'm talking about. In previous episodes, I've mentioned this whole concept of return on invested capital, and I want to dive deeper into this without hurting your head too much.

(1:35) Now, just a fair warning, I'm going to be talking numbers. I'm going to be sharing some formulas, but I'm going to try to make it as simple as possible so you could follow along from an auditory standpoint.

(1:49) Now, how companies create value, this is really important to understand. It comes down to return on invested capital combined with growth.

(1:56) So, let me explain. A company creates value when the present value of its future cash flows exceeds the cost of its investment.

(2:10) In other words, when you make an investment into a company, you want all the future cash flows in today's dollars to exceed that initial investment. Otherwise, that'd be crazy, right?

(2:22) In other words, you don't want to put a dollar into a machine and then get zero dollars back, right? If that happened to you at a vending machine, for example, you'd probably be kicking the machine until you either knocked it over and got your soda or your candy out of it, or you got your dollar back.

(2:37) No, I'm kidding. Don't be kicking a vending machine. But that's the whole thing with business. You're not going to put a dollar into a vending machine or into a cash-creating machine and get zero dollars back, or you're going to be really upset.

(2:51) So, you put money into a cash machine, aka a business, and then hopefully it spits out two dollars or three dollars or four dollars or five dollars into the future.

(2:56) Now, there's a time element to that because if you put a dollar into this cash machine and then it gives you two dollars, you're like, yes, that's great. But if you had to wait 30 years to get those two dollars back, that'd be terrible, right?

(3:12) So, that's what I'm talking about with this time component and return on invested capital and everything else.

(3:18) So, let me keep going here. When it comes to return on invested capital, every dollar invested in a business should generate more value than the same dollar that is invested elsewhere. Otherwise, you'd just be crazy.

(3:32) Now, I know there is value in owning your own company. So, for some people, they put a dollar into their business and they get 50 cents back.

(3:42) But they justify that thinking, hey, at least I don't have to go work for corporate America or whatever it may be.

(3:49) But in the long term, why would somebody ever want to put money into a business, deal with all the headaches, all the stresses, all the employee garbage, like all the things that happen in a business, in order to get a return that is less than just taking that same dollar and investing it in Apple or Google or whatever, right?

(4:05) So, when it comes to running your business, you have to consider return on invested capital, especially when it comes to strategy.

(4:15) So, let's keep going here. Let me give you an example. Let's say a company invests $10,000 and its cost of capital, in other words, its required return, is 8%.

(4:30) Now, let's consider three different scenarios here. First, value destruction. If the investment generates $500 in cash flow per year forever, then the value would be calculated simply as $500 in cash flow divided by 8%, or it would return in value $6,250.

(4:48) Now, I'm just simplifying here. But in this scenario, you put $10,000 in and you're only going to get $6,250 back into the future after you consider your cost of capital.

(5:02) So, that'd be terrible.

(5:06) I'm always talking about free cash flow, but you have to consider free cash flow in respect to your cost of capital and your return on invested capital.

(5:12) Okay? So, there's a lot to it. 70% of companies that go bankrupt are profitable when they close their doors.

(5:17) So, if you just pay attention to profit, guess what? You're in a very dangerous position.

(5:21) If you're measuring free cash flow, that's a step up. That's great. You should be paying attention to free cash flow.

(5:32) But if you're not comparing your free cash flow in relation to your return on invested capital, it could be problematic.

(5:35) All right. So, that's scenario one. You put $10,000 into the business.

(5:41) It produces $500 of positive free cash flow. So, you're thinking, I have positive cash flow. It's great.

(5:46) But over the long haul, you're only going to get $6,250 back. And therefore, it's a terrible investment.

(5:53) Here's the neutral value scenario. You take the same $10,000, but instead, cash flow grows to $800 per year.

(6:00) So, you're thinking, it used to be $500 in the previous example, so more cash flow is better. Now you're generating value, right?

(6:05) But if you take the $800 and you divide it by the 8%, that's the 8% of your cost of capital—the same math that I did in example number one—you'd get $10,000.

(6:18) Which means you put $10,000 into your business. You think you're growing free cash flow, but guess what? You only get your investment returned at a later date.

(6:24) And there are opportunity costs associated with that because your money is tied up in your business and you're not investing in other assets.

(6:33) So, here, the value equals the initial investment, meaning the company is merely covering its cost of capital, but it's not creating value.

(6:44) All right. Scenario three—hopefully, your head isn't hurting yet.

(6:48) Okay, I've got a little bit more math for you, but I really want you to understand this concept.

(6:54) Let's say your company is generating $1,100 in free cash flow, divided by that same 8% cost of capital.

(7:01) Then you would have a value of $13,750, which exceeds the initial $10,000 investment.

(7:10) So, therefore, this company is creating value.

(7:16) Now, if you didn't follow any of my math, which I don't expect you necessarily to follow because it's kind of a lot—especially to listen to—just get this point:

(7:21) Just because you have positive free cash flow and just because you may be increasing your cash flow year to year, it doesn't necessarily mean you're creating value.

(7:28) The only time you're creating value is when your return on invested capital exceeds your cost of capital.

(7:34) So, where does strategy come in?

(7:40) It all comes down to pursuing a strategy or having a strategy for your business where you can earn higher returns on invested capital compared to what it costs you to get that capital.

(7:53) So, more on that here in just a minute.

(7:59) Here's the key takeaway, though—the longer you sustain high returns, the more value you create.

(8:05) So, let's keep going, and let me explain more about the importance of return on invested capital.

(8:12) Return on invested capital (ROIC) comes into play because it measures how efficiently a company turns its capital into profit.

(8:19) The formula is net operating profit after tax, also known as NOPAT, divided by invested capital.

(8:27) NOPAT represents the company's after-tax operating income.

(8:34) Invested capital includes two things—working capital and net property, plant, and equipment.

(8:40) I say "net" because it's your gross property, plant, and equipment, minus your accumulated depreciation.

(8:46) So, return on invested capital tells us whether a company is making good use of its money.

(8:52) To illustrate why this matters, let's compare two different types of businesses.

(8:58) Let's say Company A earns $10,000 in profit, and Company B earns $5,000 in profit.

(9:06) Which one would you rather own?

(9:11) Now, you may be thinking, "Company A, of course, right? Because it's earning $10,000 in profit. Why wouldn't you want to own the company that earns more profit?"

(9:16) Well, here's the caveat.

(9:19) I know you're really smart, so I'm sure you're thinking, "There's got to be a catch. It can't be that easy."

(9:26) And there is a catch. That catch is how much invested capital is required to put into the business in order to earn those returns.

(9:32) So, Company A—yeah, they're earning $10,000 in profit, which is great. It's higher than the $5,000 of Company B, but it requires a million dollars in capital.

(9:40) In other words, the business owner of Company A has to invest money in order to have working capital.

(9:44) They have to invest in property, plant, equipment—buying trucks, tractors, machinery, all that.

(9:48) So, they have a million dollars tied up in the business, and they're earning only $10,000.

(9:53) Whereas Company B—sure, they're earning less profit. But imagine if that business only had to put in $1,000 in capital.

(9:59) It's crazy, right? You'd be earning such a higher return.

(10:04) So, at first glance, Company A might seem like the better business because it earns more profit.

(10:09) Right? That's what I thought too, initially.

(10:14) But if you calculate their return on invested capital—$10,000 divided by a million for Company A—that's only a 1% return.

(10:21) At that rate, you might as well just take your money and put it in a bank or invest in a CD or a money market account.

(10:26) Now, Company B earns $5,000 in profit, but divided by their invested capital of $1,000, that's a 500% return on their money.

(10:33) So, clearly, Company B is the better investment because it earns a higher return on every dollar invested.

(10:39) Let's talk about return on invested capital and competitive strategy.

(10:45) How does return on invested capital relate to strategy?

(10:50) Well, let me tell you.

(10:54) When a company's return on invested capital exceeds its cost of capital, it signals competitive success, which is ultimately a result of the strategy.

(11:01) Because when your return on invested capital exceeds your cost of capital, you're creating value.

(11:06) And the whole purpose of strategy—or one of the main purposes of strategy—is to increase firm value.

(11:12) Now, Michael Porter, a Harvard professor and a leading strategist, identified two main ways companies achieve a competitive advantage.

(11:18) First, through differentiation. This is when a company charges premium prices because it offers something unique.

(11:24) Think about Apple and their iPhone.

(11:29) The second way to gain a competitive advantage, according to Porter, is through cost leadership.

(11:35) This is when a company produces at a lower cost than its competitors, allowing it to charge less while also remaining profitable.

(11:42) Think about Walmart.

(11:47) So, if we break down return on invested capital into two levers, then we can understand how strategy ties into all this.

(11:53) Let me explain. Return on invested capital, the long form of all this, is NOPAT (net operating profit after tax) divided by revenue.

(12:06) Because you want to look at NOPAT expressed as a percentage of revenue.

(12:12) Then, if you multiply that by invested capital turnover—which is revenue divided by invested capital—then you can understand the two components of return on invested capital.

(12:18) Which is net operating profit after tax, expressed as a percentage of revenue, divided by invested capital.

(12:24) So, imagine this formula: ROIC equals NOPAT divided by revenue times revenue divided by invested capital.

(12:31) Well, revenue is going to cancel out. Remember, the numerator and denominator are going to cancel out in the equation.

(12:37) And therefore, you're left with NOPAT divided by invested capital, which is the short form for return on invested capital.

(12:41) I know it's kind of a lot. It's hard to illustrate it.

(12:47) I wish I could just draw you a picture here on this podcast, but this is what you should know.

(12:51) NOPAT as a percentage of revenue represents the company's profit margin.

(12:58) Revenue divided by invested capital is the invested capital turnover, or how efficiently a company uses its capital to generate revenue.

(13:04) So, when you analyze these two components, you can determine which strategy a company is executing.

(13:11) In other words, if a company has a high net operating profit after tax margin but lower capital turnover, it likely competes through differentiation.

(13:18) So, for example, a luxury car brand like Ferrari.

(13:24) If a company has high invested capital turnover but low margins, it likely competes through cost leadership.

(13:31) Example: a budget airline like Ryanair or Spirit Airlines.

(13:37) So, how does this all apply to your business? And what can you do with this information?

(13:45) Here's a simple exercise.

(13:50) First, calculate your return on invested capital.

(13:56) Find your net operating profit after tax and express it as a percentage of revenue.

(14:01) Then, calculate your invested capital turnover, which is revenue divided by your invested capital.

(14:07) After you do that, move to step two, where you analyze your competitive advantage.

(14:13) If your NOPAT margin is high, you are likely succeeding in differentiation.

(14:19) If your capital turnover is high, you are likely succeeding in cost leadership.

(14:25) If neither is high and return on invested capital is below your cost of capital—okay, no shame, I've been there before. Don't worry.

(14:31) It just means that you might be stuck in the middle with no clear advantage.

(14:36) And that's okay because you don't have to stay there. That’s the good news.

(14:42) The first step, though, is to recognize this.

(14:48) And here's the deal—to build a valuable business, if you focus on increasing your return on invested capital while ensuring it stays above your cost of capital, whether through higher margins (differentiation) or higher efficiency (cost leadership), then you can optimize your return on invested capital, which is the key to long-term value creation.

(14:54) Okay, hopefully that wasn’t too much for you, and it didn’t blow up your brain.

(15:00) But this is a really important concept that I like to look at when it comes to strategy.

(15:05) And when I talk about combining strategy and finance together, that’s what I’m referring to.

(15:09) It’s true value creation. It’s not the soft, fluffy stuff—which is okay sometimes.

(15:15) It’s the brass-tacks levers of value.

(15:20) And when you can understand what those levers are, you can have a major impact on your business.

(15:26) Because you can act with precision and focus on the things that matter the most, right?

(15:30) That’s all I have for you.

(15:35) Thanks for joining me for another episode of Business Strategy.

(15:39) And until next time, take care of yourself.

(15:42) Cheers.