4 Aug 2020

Photo by Micheile Henderson on Unsplash

By Stuart Graham and Marc Wilson

Stuart is a manager and Marc is a partner at Global Advisors.


Both are based in Johannesburg, South Africa.

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    Growth, profit or returns? It's all three, however we find that the relationship between these and shareholder value creation is poorly understood – if at all.

    All three measures become critical to the way forward as companies navigate the Covid-19 crisis.

    After ensuring business survival, navigating through the Covid-19 crisis requires returns on invested capital AND growth to deliver shareholder returns. S&P 500 companies averaged 13% RONA and 5% revenue growth (CAGR) through the financial crisis (2008-2012)i.

    Monolithic survival approaches may starve compensating growth opportunities – a portfolio approach is required.


    Key Insights

    Returns are not enough – companies must also grow to create value.

    Profits and cash flows cannot increase indefinitely through cost-reduction, efficiency, business mix, etc – top-line growth is critical.

    Returns must be above costs of capital to be value accretive.

    S&P 500 companies averaged 13% ROIC and 5% revenue growth (CAGR) through the financial crisis (2008-2012).

    Margins and revenue growth, or even profit growth in themselves don't answer that question of whether shareholder value was created or destroyed. There are many examples of where growth and high margins actually destroy value.

    Company valuations reflect an aggregate of their business portfolio – rebalancing segments based on their growth and return profiles can lift company value.

    Growth requires investment – at the very least in the working capital required to support revenue growth.

    Measuring RONA or ROIC and Revenue growth shows whether business activity is value accretive or destructive.

    You can use the Global Advisors Market Cap (valuation) framework to map your business – and agree action to deliver improved shareholder returns.

    'Look, we understand that in this Covid-19 period, our employee safety and business survival is the first priority. But we have to get our margins up. And we cannot abandon the focus on growth.'

    'What do you want from me!?' thought Jim, CEO of XCorp, leaving the boardroom frustrated.

    Jim had just presented a good set of results to the board after what was surely the most challenging financial quarter of his life. XCorp had benefitted from panic buying in the first months of the Covid-19 outbreak but now faced the question of how to sustain performance in a potentially prolonged period of economic difficulty.

    Last quarter the board had berated him for a slowdown in growth. Now he had delivered excellent (if somewhat inflated) growth and a strong profit performance but the board still wasn't happy.

    'Yes, we sacrificed a bit of margin,' he admitted to himself, 'but if we can maintain a level of growth does it really matter?'

    It felt like the board was constantly see-sawing between growth and some or other measure of profit.

    'What do our shareholders actually want though?' he pondered. 'They'll obviously say they want both, but what will actually generate the most value?'

    Reluctantly, Jim answered his own question: 'I don't know…'

    In a moment of slight panic, Jim realised answering his question had big implications for his company's portfolio.

    He had businesses at varying stages of growth and operating at very different margins. How should he balance this and what should each business focus on? And in this Covid-19 period, where should he cut and how could he invest?

    Meeting - Photo by Charles Deluvio on Unsplash
    Photo by Charles Deluvio on Unsplash

    The first thing he needed to do was stop the debate about the best measure for profit. He called in his new CFO, Alice, to see what she thought.

    'At almost all of the previous companies I've worked for, the go-to profitability measure was margin,' said Alice. 'I've always thought this was strange though, particularly given that they were asset-based businesses – surely measures like return on equity (ROE) and return on net assets (RONA – or the closely related return on invested capital or ROIC) which directly relate profit performance against deployed assets and show the relevant impact to shareholders make more sense?'

    'I agree,' replied Jim. 'If we were an asset-light, service-based business, then margin would probably be appropriate, but for our business, RONA makes sense. I still need your help though, Alice. There are three key questions I need to answer:

    1. Should we target RONA or growth – which will create more value for our shareholders?
    2. How does this impact the businesses in our portfolio?
    3. How should our RONA / growth decisions change during an economic downturn and during Covid-19?'


    Why choose RONA or ROIC as a measure of return?

    There are many potential measures of return, each with their own strengths. Return on Equity is a favourite due to its measure of actual returns accruing to shareholders. So why choose RONA or ROIC?

    RONA and ROIC have some strengths of their own:

    1. They are a measure of return on deployed assets (fixed and working capital) and thus take into account both the income statement and balance sheet.
    2. ROIC is based on net operating profit after tax or NOPAT – showing profits before interest costs. It is therefore independent of capital structure allowing useful comparison to benchmarks and the weighted average costs of capital.
    3. ROIC and RONA can therefore easily form part of an even more holistic economic profit measurement – the measure of the excess of profits earned above costs of capital.
    4. Project justification can be relatively easily be aligned with ROIC and RONA measurement through aligning hurdle rates to target performance.
    5. ROIC and RONAs can be more easily cascaded to business units and market segments.
    6. ROIC and RONA lend themselves towards use in KPI or ratio trees such as Du Pont analysis – highlighting levers to improving financial performance.

    So how are RONA and ROIC calculated?

    RONA Formula
    ROIC Formula

    where NOPAT = EBIT x (1 – tax rate)

    and Invested Capital = Fixed Assets + Net Working Capital

    For more on this calculation and cascading calculations to a business unit or segment level, please see the appendix.

    Jim's predicament is not uncommon. All businesses must determine the balance between RONA (or margin for asset-light businesses) and growth that will deliver the most value, but few have clear tools to help them make this decision. And they are seldom linked to strategy.

    In the current Covid-19 circumstances, many of our clients face the potentially paralysing choice of cutting costs, shutting businesses, laying off employees – while finding a way to deliver growth into the future. However, despite the Great Financial Crisis, the S&P 500 companies achieved 13% ROIC and a 5% revenue CAGR from 2008 to 2012i.


    Case Study

    PepsiCo beats earnings expectations during Covid-19

    Covid-19 makes managing for both RONA and growth more difficult – but no less essential. In a July 2020 interview with Bloomberg, PepsiCo CFO Hugh Johnston (Bloomberg, 2020), outlined how they had beat earnings estimates:

    1. Ensuring employee safety.
    2. Delivering against increased consumer need for trusted brands.
    3. Simplifying the business and increase efficiencies with a greater focus on stronger SKUs.
    4. Driving growth through innovation.

    The PepsiCo result is of critical importance to others looking to learn lessons for the economic downturn. Perhaps the most important lesson is the benefit of nuanced decision making and a portfolio approach. While Pepsi's beverages business came under pressure from decreased out-of-home consumption, snacking proved robust and breakfast grew as more consumers ate at home.

    The most important lesson is the benefit of nuanced decision making and a portfolio approach.

    Despite important discussions regarding 'The New Normal' and 'Pivoting Business Models,' it is critical that principled decisions are made that maintain protection and growth towards full potential in the core business while core re-invention and optimal adjacent expansions are considered. Growth is ultimately critical – even in tough times.

    Growth is ultimately critical – even in tough times.

    Driven by just such top-line growth on strong economic returns (excess of ROIC over weighted average costs of capital or WACC), the S&P 500 outperformed the JSE ALSI from 2010 to 2019 (shown below)ii.

    Figure 1

    Economic profit and growth drives the S&P

    Performance of the S&P 500 and JSE ALSI from 2010 - 2019 - Source: Global Advisors analysis
    Revenue growth, Economic return, TSR – selected S&P shares – 2010-2019 - Source: Global Advisors analysis

    Global Advisors analysis of the S&P 500 and JSE All Share Index companies shown in Figures 2 and 3 below illustrates the obvious importance of both ROIC and growth to share price performanceiii. However, the analysis reveals that investors typically reward high-growth companies more than high-ROIC companies. On the other hand, high growth at unacceptable levels of ROIC leads to diminished increases in share price. Revenue growth must result in Net Operating Profit After Tax (NOPAT) growth above WACC in order to be value accretive.

    Revenue growth must result in NOPAT growth above WACC in order to be value accretive.

    Figures 2 and 3

    The impact of ROIC (or RONA) and growth on shareholder returns

    Figure 2 and 3: S&P 500 and JSE ALSI constituents – Total Shareholder Returns (TSR), Median ROIC, Annual Revenue Growth – 2010 to 2019

    Average TSR per grouping in bold figures

    TSR for S&P500 shares by revenue growth, ROIC – 2010-2019 - Source: Global Advisors analysis
    TSR for JSE ALSI shares by revenue growth, ROIC – 2010-2019 - Source: Global Advisors analysis
    Figures 2 and 3 demonstrate that while ROIC and top-line growth both have a positive impact on share price performance, investors typically reward growth more than ROIC.

    Strong and consistent ROIC or RONA performers provide investors with a steady flow of discounted cash flows – without growth effectively a fixed-income instrument. Improvements in RONA through margin improvements, efficiencies and working-capital optimisation provide point-in-time uplifts to share price.

    Top-line growth presents a compounding mechanism – RONA (and improvements) are compounded each year leading to on-going increases in share price.

    However, without acceptable levels of RONA, the benefits of compounding will be subdued and share price appreciation will be depressed.

    Getting the right balance between RONA and growth is critical to optimising shareholder value.

    Figure 4

    Growth and ROIC account for value

    Figure 4 shows that despite significant impact of sentiment and other factors – growth and ROIC account for a substantial contribution towards total shareholder returns / company value

    Regressed contribution towards total returns – 2010 – 2019 – weighted percent

    • Growth contribution to S&P 500 TSR 33% 33%
    • ROIC contribution to the S&P 500 TSR 26% 26%
    • Growth contribution to the JSE ALSI TSR 13% 13%
    • ROIC contribution to the JSE ALSI TSR 5% 5%

    Source: Global Advisors analysis

    Investors and managers should also be attuned to the asset life stage impacts on RONA or ROIC. Steadily improving or large RONA results can indicate a lack of reinvestment that fatally sabotages future growth.

    It is not uncommon to see underinvestment result in future growth crises where managers attempt to frantically cut costs to sustain unrealistically high RONAs or reignite growth in businesses after years of tepid top-line performance.
    Growth and RONA are inextricably linked for a further reason – growth requires capital to support higher levels of sales. There must be continued investment in operating assets to maintain and expand productive capacity to support growth – at the very least in the form of working capital.

    Therefore, returns on growth are critically reliant on an optimised reinvestment rate and productive use of capital. High performing businesses portfolio manage their investment lifecycle to optimise offsetting the dilutive impact of new investment.

    We will return to the strategic approach to finding growth later, but let's first consider the fundamental growth and RONA imperative to protect and deliver value to investors.

    The right decisions for your business are dependent on your current RONA / growth combination. The right decision will also be different for each of the businesses in your portfolio. On a recent Global Advisors engagement, our client faced a very similar position to Jim. We used the Global Advisors RONA / growth methodology to demonstrate that the RONA and growth trade-off must be managed for every business portfolio.

    The right decision will also be different for each of the businesses in your portfolio.

    How much growth, how much RONA?


    Growth and RONA impact company valuation differently. Company value is the discounted sum of all future cash flows compounded by growth. Profits and cash flows cannot increase indefinitely through cost-reduction, efficiency, business mix and so on – so top-line growth is critical.

    We make use of the 'Key Value Formula' to describe the relationship mathematically and understand the relative sensitivity to RONA and growth.

    We introduced our client to the 'market capitalisation curve' (or 'valuation curve' for an unlisted company). Plotting the equation for combinations of RONA and growth at the current share price / valuation reveals a curve illustrating all combinations of RONA and growth which deliver against current valuations.

    Plotting the equation for combinations of RONA and growth at the current share price / valuation reveals a curve.

    Just like Jim at XCorp, our client's strong growth performance but relatively low RONA placed it on the lower right portion of the curve.

    This tool allows us to answer Jim's first question – 'RONA or growth?' We can immediately see that from XCorp's (and our client's) position on the curve a drop in RONA requires a disproportionate increase in growth to maintain the current share price.


    The Key Value Driver formula

    We use the Key Value Driver formula to understand the relative impact of ROIC or RONA and Growth on company valuation.

    Key Value Driver Formula

    Figures 5 and 6

    The Market Cap (Valuation) Curve

    Figure 5: Example company RONA/growth combinations maintaining share price
    Valuations for different sales growth / RONA combinations - Source: Global Advisors
    Figure 6: The market-cap curve
    The market-cap curve – RONA / growth combinations to maintain a defined market cap - Source: Global Advisors
    Any combination of RONA and growth lying on the curve will maintain the current share price (or valuation).
    As seen in Figures 5 and 6, the generalised result from the curve is clear: high-RONA companies will benefit more from growth and high-growth companies will benefit more from RONA.

    Companies reflect portfolios however. Decomposing company portfolios into a map of business segment RONA / growth performance allows for nuanced management and action.

    Businesses whose RONA / growth combination placed them above the curve were value accretive while those below were value destructive.

    We plotted individual business units against the company's market cap curve. Businesses whose RONA / growth combination placed them above the curve were value accretive while those below were value destructive.

    When we showed this to our client, there was an immediate response – no manager wanted to be below the line and rushed to figure out what to do to improve their business unit performance. A simple plot had a large mobilisation impact. Critically, the methodology was driven by the CEO and Exco team and incentive structures were adjusted to align with the approach.

    A simple plot had a large mobilisation impact.

    Plotting businesses against the market-cap curve provides a tool to help answer Jim's second question – 'How does RONA/growth measurement impact businesses in a portfolio?' All businesses lying above the curve should focus on maintaining or improving their position, while businesses below the line should identify plans to move above the line. All such movements have the impact of raising the company value – and shifting the market cap curve further out!

    Figure 7

    Business segment placement on the market-cap curve

    Segment RONA versus two year growth - Source: Global Advisors
    • Business segments lying above the market-cap curve are value accretive.
    • Business segments lying below the market-cap curve are value destructive.
    • Value accretive business segments need to ensure their positions above the curve are maintained (or improved) while value destructive business segments must formulate plans to improve RONA / growth to move above the curve.
    • Any improvements to RONA/growth raise the company value and shift out the market-cap curve.

    Figure 8

    Sequence of RONA / growth improvements

    Optimal sequence of value moves for businesses - Source: Global Advisors
    1. Low-RONA businesses should first target improvement of RONA performance to an acceptable level before pursuing growth. At low RONA performance compounding from growth will deliver a suppressed benefit – and at RONAs below WACC will actually destroy shareholder value.
    2. While there are valid strategic reasons for pursuing growth at discounted levels of RONA (such as establishing a critical market share), these should be in support of ultimately achieving an optimal RONA / growth relationship.

    Each business's targets need to consider industry benchmarks for RONA and growth to ensure that realistic goals are set.

    There will always be business units positioned below the curve, but where this is a long-term business-model or industry concern with limited potential for improvement, the business unit's position in the portfolio must be carefully considered.

    Business and industry maturity impact the ability to achieve RONA and growth targets. It is typically harder to sustain high rates of growth over the long term than it is to deliver sustainable RONA performance. Almost inevitability, business segments tend to exchange growth for RONA over time – reflecting the need for ongoing portfolio optimisation.

    We recommended that our client further evaluate the balance of its portfolio in this context. Achieving company-level RONA / growth targets requires a balance of businesses in varying stages of maturity.


    Applying the market-cap curve in an economic downturn


    Covid-19 has placed strain on economies around the globe.

    We again used the market-cap curve to support Jim's third question: 'How does an economic downturn affect our decisions about RONA and growth?'

    Your first decision should be whether to adopt an offensive or defensive strategy – and how this should vary by industry, business unit and segment. While a company may find itself in a strained position in aggregate, starving those business units and segments with growth and RONA potential can make a bad situation terminal for the portfolio and company.

    Starving those business units and segments with growth and RONA potential can make a bad situation terminal for the portfolio and company.

    Companies with strong strategic and financial positions leading into the downturn may be well suited to go on the offence and capitalise on the pressure weaker competitors face. Less well-positioned companies should focus on defending their current position.


    Figure 9

    Checklist for operating during a downturn

    As published in 'Making a Key Decision in a Downturn: Go on the Offensive or be Defensive?' (Ivey Business Journal)

    The market-cap curve should be used to benchmark the requirements of your chosen strategy. The balance of business unit positions against the curve demonstrates the requirements at a nuanced level and the overall challenge for the company. Prioritisation is critical.

    Application of the market-cap curve should also be considered in the context of the downturn. It may be acceptable for a business unit to fall below the curve during this period if there is a clear path to an improved position in the future.

    Offensive opportunities should target growth and strategic investments. Companies should determine the balance of RONA and growth required to deliver optimal shareholder value given the likely market conditions going forward. While there may be acquisition opportunities at depressed prices, acquisitions made during the downturn should be value accretive and strengthen or help redefine the core.

    The market-cap curve should help benchmark your strategy for surviving the downturn and capitalising on the recovery.

    Companies facing defensive business segment requirements should protect revenues and margins while optimising the balance sheet. Assuming limited growth, companies should determine the RONA target required for the business segment required to meet shareholder value expectations based on the market-cap curve. Costs and efficiencies must then be managed aggressively to reach these targets.

    Where companies are unable to take offensive opportunities based on their aggregate portfolio positions, restructuring opportunities should be considered to avoid damaging the prospects of star business segments.
    The market-cap curve provides a tool to understand relative sensitivity to changes in RONA and growth. It can help identify where to focus as a company and at a business-unit level.

    If your projected RONA and growth positions are below (or above) your company's current valuation (implied by aggregate positions below or above your Covid-19 market cap curve), then this implies a mismatch between investor expectations and projected performance. Such disconnects might be sustainable in the short-term, but ultimately should see a valuation adjustment. They might also imply an imperative for a more aggressive approach to achieving RONA and growth improvement.

    Regardless of whether an offensive or defensive strategy is selected, companies need to understand the nuanced needs of the businesses in the portfolio. For some businesses it may be necessary to shift focus onto the economy products within the portfolio or target different pack sizes. Cost-cutting may be required in some business units while others may require investment despite the short-term impact on performance. For PepsiCo, a strong focus on the snacking and breakfast categories helped offset declines in its beverage category during the early stages of the Covid-19 downturn.

    However, the curve is only a financial tool and cannot on its own be used to evaluate the composition of a portfolio. The tool should be used to support broader strategic thinking about a company's portfolio.


    As you evaluate your approach you should ask yourself a few questions:

    1. How are you feeding your growth and RONA stars to deliver immediate maximum results?
    2. How are you ensuring outward focus to meet changing consumer needs and perceptions of value?
    3. How should you define your core and adjacencies for the future?
    4. How are you supporting segments that will be growth and RONA stars in the future?
    5. How do you need to adjust your portfolio?
    6. How are you aligning your strategy with market expectations on a risk-adjusted basis?
    7. How do the survival actions you are taking support your strategy?
    8. How will your strategy allow you to capitalise on the upturn?


    Read more

    In other articles in this series, we discuss our integrated strategic and financial approach to corporate portfolio strategy:

    1. Understand and align the core business as the basis of optimising a corporate portfolio.
    2. Use portfolio techniques to highlight growth opportunities in the core and adjacent areas.
    3. Integrate with modern financial theory to clearly deliver increased shareholder value.

    We also discuss opportunities that companies operating in low-growth and margin-pressured environments have to deliver shareholder value.

    Covid-19 also demands that strategy caters for increased levels of uncertainty. Sign up for our email newsletter below for our upcoming perspective on strategy in the face of uncertainty.

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    Understanding the market-cap curve

    A company's value as expressed through market capitalisation (or share price) can be viewed as the present value of future economic profits plus the capital that has been invested.


    Key Value Driver Formula

    This formula is fairly intuitive: share price is immediately increased by improving profitability (NOPAT and RONA) and this is compounded through top-line growth.

    The measure that will have the biggest impact on company value depends on the company's current RONA/growth performance.

    Plotting the relationship between RONA and growth helps make this clearer.

    Figure 10

    The market-cap curve

    The market-cap curve – RONA / growth combinations to maintain a defined market cap - Source: Global Advisors

    Each point on the curve represents a combination of RONA and growth delivering the current company value (market capitalisation or share price).

    Clearly there is a trade-off between RONA and growth: at higher values of RONA less growth is required to support the share price and vice versa.

    Therefore, in the short-term, the sensitivity will be based on the current RONA / growth position: a high-RONA business will get the biggest boost by improving growth, whereas a high-growth business will get the biggest boost by improving RONA.

    Importantly, RONA/growth combinations falling below current company WACC should not be considered feasible positions on the curve. In such situations, RONA performance is not sufficient to cover cost of capital and the company's first objective should be to raise RONA performance above the WACC threshold.

    In the longer-term, there is only so much gain that can be achieved through profitability improvements without top-line growth. At some point there will be no more gains available through cost-reduction, efficiencies and business mix and your share price will stagnate.

    Using the market cap curve to evaluate a business portfolio 


    The market-cap curve provides a set of RONA / growth thresholds that need to be met to maintain current share price.

    The market-cap curve can therefore be used as a tool to evaluate individual business segments' performance and contribution to the company's valuation. The tool can be setup using the following steps:

    1. Plot the company market-cap curve using formula (1) at current NOPAT and WACC allowing RONA to vary as different levels of growth are selected.
    2. Calculate business segment RONA and growth.
    3. Plot business segment actual RONA and growth against the market-cap curve.

    Figure 11

    Business segment performance against the market cap curve

    Segment RONA versus two year growth - Source: Global Advisors

    Any business segment in a company's portfolio that exceeds these thresholds will be value-accretive while those that fall below will be value-destructive. It is inevitable that there will be a mix of business units lying above and below the curve – company value represents an aggregate of business unit performance.


    Calculating business segment RONA or ROIC

    For this purpose, we define RONA as:

    NOPAT / (PPE + Receivables + Inventory – Payables)

    This represents an operating RONA – all non-operating items such as Intangibles are excluded.

    RONA is not always readily available at a business segment level and usually requires finance and operational teams working together.

    While the most accurate view may require complicated cost allocations, a directionally correct allocation is usually sufficient for the purposes of using the market-cap curve.

    NOPAT is usually available at business segment level – when this is not the case, costs need to be appropriately allocated to provide an accurate view of business segment performance.
    Balance sheet information is often not available at business segment level and needs apportionment to provide a fair view of net assets.

    • PPE directly employed by a business segment is easily allocated while shared PPE needs to be apportioned using an appropriate methodology agreed between finance and operations.
    • Receivables and payables should be apportioned according to business segment sales and cost of purchases respectively – raw material inputs shared across business segments must be apportioned.
    • Inventory can be calculated using actual finished goods and raw material stock levels – raw material inputs shared across business segments must be apportioned.
    • Depreciated replacement value of PPE should be used in the RONA calculation rather than book value – otherwise business segments with newer assets will be penalised relative to business segments with older assets.
    • Poorly understood PPE values can lead to falsely inflated or depressed RONA which can lead to incorrect portfolio investment decisions.


    1. Koller, T; Goedhart, M; Wessels, D – 'Valuation: Measuring and Managing the
      Value of Companies' – 2010 – pp 40-41 – John Wiley & Sons, Inc
    2. Kansal, C; Deans, G; Mehltretter, S – 'Making a Key Decision in a Downturn:
      Go on the Offensive or be Defensive?' – 2009 – Ivey Business Journal –
    3. “Pepsico Beats as Consumers Come Back to 'Big Trusted Brands': CFO” – Bloomberg – 13 July 2020 – https://www.youtube.com/watch?v=wZ-I_rnZboY

    Calculation methodology and notes

    Data sourced from gurufocus.com and Global Advisors analysis.

    Calculations of RONA and WACC as per gurufocus.com.

    Averages and calculations exclude index components where data is incomplete over the 2010 to 2019 period.

    All calculations are based on components of indices as at 19th July 2020, and where weightings were applied, based on their weighting value as at this date – changes to index components and weighting over the calculation period were not taken into account.

    Calculations and averages include financial services shares. Where this is the case, ROE was used instead of RONA.

    i Unweighted average of RONA and CAGR of individual shares.

    ii S&P 500 and ALSI component stock values weighted by market capitalisation values at 19th July 2020. Individual stock RONA, WACC, annual revenue growth and total shareholder returns as per gurufocus.com. Economic profit as calculated by Global Advisors.

    iii Groupings as per Global Advisors analysis. RONA per share based on 10-year median. Revenue growth per share based on 10-year average. Regression values based on all shares with complete data for the 2010 to 2019 period.

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