Valuation: Measuring and Managing the Value of Companies, Fifth Edition

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Fundamental Principles of Value Creation

In Chapter 1, we introduced the fundamental principles of corporate finance. Companies create value by investing capital to generate future cash flows at rates of return that exceed their cost of capital. The faster they can grow and deploy more capital at attractive rates of return, the more value they create. The mix of growth and return on invested capital (ROIC)¹⁰ relative to the cost of capital is what drives the creation of value. A corollary of this principle is the conservation of value: any action that doesn’t increase cash flows doesn’t create value.

The principles imply that a company’s primary task is to generate cash flows at rates of return on invested capital greater than the cost of capital. Following these principles helps managers decide which investments will create the most value for shareholders in the long term. The principles also help investors assess the potential value of alternative investments. Managers and investors alike need to understand in detail what relationships tie together cash flows, ROIC, and value; what consequences arise from the conservation of value; and how to factor any risks attached to future cash flows into their decision making. These are the main subjects of this chapter. The chapter concludes by setting out the relationships between cash flows, ROIC, and value in the key value driver formula—the equation underpinning discounted cash flow (DCF) valuation in both theory and practice.