Professional Documents
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Valuation Framework
Content:
I. Theoretical Drivers of Firm Valuation
II. Why Focus on ROIC?
III. Using the ROIC Curve as a Screening Tool
IV. ROIC Curve Empirical Results
V. The ROIC Curve Versus Traditional Valuation Anomalies
This information is intended to be general in nature and should neither be construed as investment advice nor a recommendation of any
specific security or strategy.
Published October 2013. For financial professional use only. Do not distribute to the public.
Executive Summary
EXECUTIVE SUMMARY
This paper examines the effectiveness of various valuation drivers in screening for companies that are potentially
pre-disposed to outperform on a relative basis. Of the five drivers put forth by Merton Miller and Franco
Modigliani in their seminal 1961 work on valuation, our analysis narrows to one driver that has proven over
time to be an effective filter: Return on invested capital, or ROIC. This does not mean that Miller-Modiglianis
other drivers are any less important; our conclusion is that ROIC is better deployed in a screening phase of an
investment process and the other drivers, less effective as screens, are better utilized later in the fundamental
research phase of our investment process as validation or rejection of the screen findings. Based on our findings,
we believe:
ROIC is an effective, time-tested screen for finding companies with the potential to outperform
The ROIC Curve, our proprietary screening mechanism, plots the relationship between ROIC and Enterprise
Value/Invested Capital (a proxy for market valuation) and effectively reveals which companies may be mis-
priced by the market and are therefore potentially pre-disposed to outperform
When coupled with rigorous fundamental research, which then includes other Miller-Modigliani measures
and other drivers, this screening mechanism has produced proven investment results over time
Measurability
Automation/
Efficiency
Fundamental
Insight
ROIC
NOPAT
GROWTH
WACC
CAP
Strong
Medium
Weak
ROIC
NOPAT
GROWTH
WACC
CAP
Cross-Factor
Correlation
Efficacy
Value, Compared
Improving returns on invested capital creates more value than growth (except when ROIC is already high).
Value Created by 1% Faster Growth1 %
26
16
6
Baseline ROIC
0
9
12
20
7
Baseline ROIC
12
20
ROIC in 2003
510%
<5%
1520%
1015%
>20%
ROIC in 1994
<5%
43
510%
1015%
28
12
31
40
25
21
1520%
18
>20%
19
17
25
19
6
18
17
25
13
13
% of Companies
that Stayed the
Same
11
11
20
50
% of Companies
that Moved to a
Higher Level
% of Companies
that Moved to a
Lower Level
510%
<5%
<5%
67
15
1015%
1520%
>20%
7
5
510%
64
16
12
1015%
61
15
11
11
59
1520%
56
>20%
% of Companies
that Stayed the
Same
*SOURCE: MCKINSEY & CO.
11
13
14
10
% of Companies
that Moved to a
Higher Level
13
% of Companies
that Moved to a
Lower Level
EV / IC
4
3
2
1
-10% -5%
0
0%
5%
5
4
EV / IC
10
2
1
-10% -5%
0
0%
Stock B
Negative "delta Y"
potential undervaluation
5%
11
8%
10
6%
4%
2%
0%
-2%
-4%
-6%
10
5%
4%
3%
2%
1%
0%
-1%
-2%
-3%
8%
6%
4%
2%
0%
-2%
-4%
-6%
-8%
-10%
10
10
Delta Y Deciles from 19862012, 3-Year Holding Period. Decile 1 represents largest negative delta Ys; GICS sectors equal weighted to avoid large sector bias.
Earnings Growth
12
4%
8%
16%
24%
4%
6.1x
12.5x
15.7x
16.7x
6%
1.3
12.5
18.1
20.0
8%
NM
12.5
21.3
24.2
10%
NM
12.5
25.5
29.9
13
14
CONCLUSION
Given GIVs long-term investment horizon and
concentrated position sizes, it is critical that our
investment professionals maintain an intimate
understanding of each of our investment positions.
The rigorous depth of research conducted on each
investment opportunity is both enabled and focused
by having a screening mechanism that allows our
team to narrow their research to opportunities that are
pre-disposed to outperform and subject to extensive
fundamental research, and have a high probability
REFERENCES
Cao, Bing; Jiang, Bin; and Koller, Timothy, "Balancing
ROIC and Growth to Build Value," McKinsey on
Finance, Spring 2006.
Mauboussin, Michael J., M&M on Valuation,
Mauboussin on Strategy, 14 January, 2005.
Miller, Merton H. and Franco Modigliani, Dividend
Policy, Growth, and the Valuation of Shares, The Journal
of Business, October 1961.
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