Transcript Thinking about ROIC and Growth Empirical Analysis of ROIC • Through this point, we have examined a general model of value.

Thinking about ROIC and Growth
Empirical Analysis of ROIC
• Through this point, we have examined a general model of value creation using
economic theory and case studies. But how does ROIC and growth behave on
an aggregate empirical basis?
• To answer this question, McKinsey & Company analyzed the corporate
performance of more than 5,000 US-based non-financial companies for a period
of 40 years (1963 – 2003).
KEY FINDINGS
Median ROIC between 1963 and 2003
Percent of companies between 5% and 15% ROIC
9%
50%
• Also, median ROIC differs by industry and growth, but not by company size.
• And individual-company ROICs gradually regress toward medians over time but
are somewhat persistent. Fifty percent of companies that earned ROICs greater
than 20 percent in 1994 were still earning at least 20 percent 10 years later.
1
ROIC Over Time: Non-Financial Companies
• When measured with
goodwill, the spread does
not widen. This implies that
top companies are
purchasing other top
performers yet paying full
price for the acquired
performance.
Average
15.3
Percent
• Companies with strong
barriers to entry have
achieved increased profits
from drops in raw material
prices and labor productivity.
Annual ROIC without goodwill
9.0
5.0
Annual ROIC with goodwill
Average
13.6
Percent
• Since 1986, the ROIC
spread across companies
has gradually widened,
driven primarily by
companies at the top end.
8.3
4.7
Source: Compustat, McKinsey & Company’s corporate performance database
2
Distribution of ROIC: Non-Financial Companies
•
84% of all ROIC observations
were below 20%.
•
If your forecast model
requires an ROIC > 20% to
generate value, how skeptical
should you be?
Annual ROIC without goodwill, 1963-2003
18
Percent of sample
16
14
12
10
8
6
4
2
0
ROIC
<-10.0 -5.0
Percent of
observations
below ROIC
level
5
7
0.0 2.5
5.0
7.5 10.0 12.5 15.0 17.5 20.0 22.5 25.0 30.0 35.0 40.0 >40.0
11
25
42
15
56
66
74
80
84
87
89
92
94
95 100
Approximately 50% of the sample
is within ROIC range of 5-15%
Source: Compustat, McKinsey & Company’s corporate performance database
3
Median ROIC by Industry Group
• ROIC varies by industry, whereas industry performance is quite stable. Therefore,
industry membership can be an important predictor of forecasted performance.
Annual ROIC without goodwill**
Amounts in Percent
Pharmaceuticals and biotechnology
Household and personal products
Software and services
Media
Commercial services and supplies
Semiconductors and equipment
Health care equipment and services
Food, beverage, and tobacco
Hotels, restaurants, and leisure
Technology hardware, and equipment
Automobiles and components
Capital goods
Food and staples retailing
Consumer durables and apparel
Retailing
Total sample
Materials
Energy
Transportation
Telecommunication services
Utilities
1963-2003
1994-2003
18.4
21.8
15.2
18.8
15.0
18.1
14.7
14.3
12.8
13.2
11.9
12.4
11.3
14.8
11.0
11.9
10.3
9.2
10.3
10.3
9.9
10.5
9.9
11.8
9.6
9.6
9.5
10.8
9.0
9.5
9.0
9.5
8.4
7.7
6.9
The majority of
industries had
median ROICs
between 9%
and 12%
7.9
7.6
7.6
6.5
5.7
6.2
6.1
Source: Compustat; McKinsey & Company’s corporate performance database
4
ROIC Segmented by Size and Revenue Growth
• Size shows no clear relation
with ROIC. Efficiency gains from
scale may be outweighed by
bureaucratic inefficiencies or
other inflexibilities.
Revenues
2005001,000<200 M 500 M 1,000 M 2,500 M >2,500 M
<0%
3.3
5.2
6.0
6.5
7.0
0-5%
8.0
7.7
8.0
8.1
9.1
5-10%
8.9
9.3
9.6
9.5
10.3
10-15%
10.8
10.9
11.2
10.9
11.8
15-20%
11.9
11.1
11.7
11.5
11.9
>20%
12.4
11.9
11.8
11.8
11.6
ROIC increases with
higher growth rate
• This does not mean that growth
causes strong performance, but
rather that certain underlying
factors enable both growth and
ROIC (e.g. fast growing
industries need not compete on
price to grow revenues).
Annual ROIC without goodwill, 1963-2003
Percent
3-year real growth rate
• ROIC appears to be positively
correlated with revenue growth,
but has no relation to size.
No clear relation between
size and performance
Source: Compustat, McKinsey & Company’s corporate performance database
5
ROIC Decay Analysis: Non-Financial Companies
• ROIC demonstrates a pattern of mean reversion. Companies earning high returns
tend to gradually fall over the next fifteen years and companies earning low returns
tend to rise over time.
• However, there is a continued persistence of superior performance beyond ten
years. ROIC does not fully regress to the aggregate median of 9 percent.
Median ROIC of portfolio*
ROIC
Percent
Percent
At time 0, companies
are grouped into one of
five portfolios, ranked
by their current ROIC
>20
15-20
10-15
5-10
<5
Number of years following portfolio formation
Source:Compustat; McKinsey & Company’s corporate performance database
6
ROIC Decay Analysis: Consumer Staples Industry
• When benchmarking historical decay, it is important to segment by industry. For
example, companies in the consumer staples industry regress much more slowly
than companies overall.
• In the consumer staples industry, even after 15 years, the original class of top
performers outperform the worst performers by more than 13 percent.
Median ROIC of portfolio*
ROIC
Percent
Percent
At time 0, companies
are grouped into one of
five portfolios, ranked
by their current ROIC
>20
15-20
10-15
5-10
<5
Number of years following portfolio formation
Source:Compustat; McKinsey & Company’s corporate performance database
7
ROIC Transition Probability (1994-2003)
Companies with ROIC’s between
10% and 20% show little
persistence, landing in any group
with an equal probability
43% of companies with
ROIC of < 5% in 1994 still
have an ROIC of < 5% ten
years later
ROIC in 2003
<5
5-10
ROIC in 1994
<5
10-15
43
5-10
10-15
Total
28
31
15-20
18
>20
19
12
40
21
5
>20
6
17
25
19
15-20
7
25
20
13
11
100
6
11
17
13
100
18
100
100
25
50
50% of
companies with
ROIC of >20% in
1994 still have
ROIC of >20%
ten years later
100
Source:Compustat; McKinsey & Company’s corporate performance database
Transition probability analysis confirms that ROIC shows considerable
persistence, especially at high and low ROIC performance levels
8
Empirical Analysis of Corporate Growth
• Through this point, we have examined how ROIC behaves over time. But how
does corporate revenue growth behave on an aggregate empirical basis?
• To answer this question, McKinsey & Company analyzed the corporate
performance of more than 5,000 US-based non-financial companies for a period
of 40 years (1963 – 2003).
KEY FINDINGS
• Median revenue growth rate between 1963 and 2003 equals 6.3% in real terms
and 10.2 percent in nominal terms. Real revenue growth fluctuates more than
ROIC, ranging from 1.8% in 1975 to 10.8% in 1998.
• High growth rates decay very quickly. Companies growing faster than 20% in
real terms typically grow at only 8 percent within five years and 5 percent within
ten years.
• Extremely large companies struggle to grow. Excluding the first year, companies
entering the Fortune 50 grow at an average of only 1 percent (above inflation)
over the following fifteen years.
9
Revenue Growth Over Time: Non-Financial Companies
• The annualized median (real) revenue growth rates between 1963 and 2003 equals
6.3%. This is quite high, especially when compared to U.S. GDP growth of 3.3%
• Why the difference? The sample only includes public companies, and GDP growth
fails to capture international growth of domestic companies.
3-year rolling average of real revenue growth
CAGR
Percent
Percent
15.4
6.3
-0.2
• Median revenue
growth demonstrates
no trend over time.
• Beginning in 1973, ¼
of all companies
actually shrank in real
terms in a given year.
Source: Compustat; McKinsey & Company’s corporate performance database
10
Revenue Growth by Industry Group
• Real revenue growth varies dramatically by industry. Unlike ROIC, rankings of
industries based on growth vary over time.
Annual real revenue growth (%)**
1963-2003
Software and services
Semiconductors and equipment
Health care equipment
Technology hardware
Pharmaceuticals and biotech
Commercial services/supplies
Telecommunication services
Hotels, restaurants, and leisure
Energy
Media
Retailing
Transportation
Food and staples retailing
Total sample
Automobiles and components
Household/personal products
Capital goods
Consumer durables/apparel
Utilities
Food, beverage, and tobacco
Materials
1994-2003
20.1
19.9
16.1
15.4
13.8
13.1
10.5
10.1
15.6
9.9
11.0
9.4
18.5
9.3
8.5
8.0
14.8
8.3
9.2
7.7
8.6
7.6
7.4
6.8
6.3
5.3
8.0
6.3
7.9
5.9
5.4
4.6
5.9
5.1
4.8
4.5
4.3
3.9
4.6
4.2
3.3
3.8
Source:Compustat; McKinsey & Company’s corporate performance database
11
Revenue Growth Decay Analysis
Median growth of portfolio*
• Growth decays very quickly;
for the typical company, high
growth is not sustainable.
Revenue
growth
Percent
Percent
• By year five, the highest
growth portfolio outperforms
the lowest-growth portfolio
by less than 5%.
>20
15-20
10-15
• Although ROIC is persistent
(high ROIC companies often
continue to generate high
ROIC), growth is not.
5-10
<5
Number of years following portfolio formation
Source:Compustat; McKinsey & Company’s corporate performance database
12
Average Revenue Growth Rate for the Fortune 50
• Most large companies struggle to grow once they reach a certain size. Consider the
real revenue growth rate for companies entering the Fortune 50.
• Although growth is strong before companies enter the Fortune 50, growth drops
dramatically after inclusion. During five of fifteen years after inclusion, Fortune 50
companies actually shrink (in real terms)!
Average annual real revenue growth rate (%)
28.6
Before entrance to Fortune 50
20.0
15.0
After entrance to Fortune 50
13.5
9.5 9.0
2.0 1.4
0.7 1.2 0.1
2.1 2.8
5.1 4.5
-0.7 -0.7
-5
-4
-3
-2
-1
0
1
2
3
4
5
-0.1
-1.6
6
7
8
9
10 11 12
-3.9
13 14 15
Years from entrance into Fortune 50
Source: Corporate Executive Board, “Stall Points: Barriers to Growth for the Large Corporate Enterprise”, 1998
13
Revenue Growth Transition Probability (1994-2003)
• But are there some companies that can growth faster than the norm? In short, the
answer is no. An analysis of transition probabilities shows that most companies
growth at less than 5% ten-years later, regardless of their initial growth rate.
Revenue growth
in 2003 (%)
<5
5-10
<5
5-10
Revenue
10-15
growth
in 1994
15-20
(%)
>20
67
64
61
59
56
Over 50% of companies in
each revenue growth category
in 1994 had <5% revenue
growth ten years later
15
10-15
15-20
>20
Total
8
3
7
100
5
100
16
12
3
15
11
4
9
100
5
11
100
13
100
11
13
14
10
8
Only 21% of companies with
20% or greater revenue in 1994
have at least 15% revenue
growth ten years later
14
Closing Thoughts
• When building a DCF model, we too often become caught up in the details of
financial statements and forget the economic fundamentals: a company’s value is
driven by ROIC and revenue growth.
• Therefore, it is critical to benchmark your forecasts of ROIC and growth against
economy-wide, as well as industry-based, empirical data.
• A company’s ROIC will only exceed WACC for an extended period if it has a
competitive advantage with barriers to entry and imitation. High ROIC is typically
driven by the ability to charge a price premium, low costs, or efficient use of capital.
Empirically speaking, ROIC over time reverts to the mean, but companies can
persistently achieve high ROICs.
• Conversely, few companies can sustain high growth for periods greater than five
years. Even Fortune 50 companies struggle to maintain revenue growth, shrinking in
five of the fifteen years following entrance into the elite group.
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