Thinking about ROIC and Growth Empirical Analysis of

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, Mc. Kinsey & 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, Mc. Kinsey & Company’s corporate performance database 2

Distribution of ROIC: Non-Financial Companies • 84% of all ROIC observations were below 20%. Annual ROIC without goodwill, 19632003 Percent of sample • If your forecast model requires an ROIC > 20% to generate value, how skeptical should you be? 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, Mc. Kinsey & 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 1963 -2003 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 1994 -2003 The majority of industries had median ROICs between 9% and 12% Source: Compustat; Mc. Kinsey & 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. 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, Mc. Kinsey & 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 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; Mc. Kinsey & 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 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; Mc. Kinsey & 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 ROIC in 1994 <5 5 -10 Total 10 -15 15 -20 >20 <5 100 5 -10 10 -15 100 15 -20 100 >20 100 50% of companies with ROIC of >20% in 1994 still have ROIC of >20% ten years later Source: Compustat; Mc. Kinsey & 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, Mc. Kinsey & 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 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; Mc. Kinsey & 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 revenue growth (%)** 1963 -2003 1994 -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 Source: Compustat; Mc. Kinsey & 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. • Although ROIC is persistent (high ROIC companies often continue to generate high ROIC), growth is not. Revenue growth Percent • By year five, the highest growth portfolio outperforms the lowest-growth portfolio by less than 5%. >20 15 -20 10 -15 5 -10 <5 Number of years following portfolio formation Source: Compustat; Mc. Kinsey & 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 revenue growth rate (%) 28. 6 Before entrance to Fortune 50 20. 0 15. 0 After entrance to Fortune 50 13. 5 9. 0 2. 0 1. 4 0. 7 1. 2 0. 1 2. 8 5. 1 4. 5 -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 10 -15 15 -20 >20 Total <5 100 5 -10 Revenue 10 -15 growth in 1994 15 -20 (%) >20 100 Over 50% of companies in each revenue growth category in 1994 had <5% revenue growth ten years later 100 100 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. 15