1. Thinking about ROIC and Growth

2. 1 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 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. Median ROIC between 1963 and 2003 9% Percent of companies between 5% and 15% ROIC50%

3. 2 Source: Compustat, McKinsey & Company’s corporate performance database Annual ROIC without goodwill Annual ROIC with goodwill Average 15.3 9.0 5.0 13.6 8.3 4.7 Average ROIC Over Time: Non-Financial Companies Percent Since 1986, the ROIC spread across companies has gradually widened, driven primarily by companies at thetop end. Companies with strong barriers to entry have achieved increased profits fromdrops in raw material prices and labor productivity. When measured with goodwill, the spreaddoes not widen. This implies that top companies are purchasing other top performers yet paying full price for the acquired performance.

4. 3 Distribution of ROIC: Non-Financial Companies Source: Compustat, McKinsey & Company’s corporate performance database Annual ROIC without goodwill, 1963-2003 Approximately 50% of the sample is within ROIC range of 5-15% Percent of observations below ROIC level <-10.0 -5.00.02.55.07.510.012.515.017.520.025.030.035.040.0>40.022.5 5711152542566674808789929495 100 84 ROIC Percent of sample 84% of all ROIC observations were below 20%. If your forecast model requires an ROIC > 20% to generate value, how skeptical should you be?

5. 4 Median ROIC by Industry Group Source: Compustat; McKinsey & Company’s corporate performance database Amounts in Percent 1994-20031963-2003 Annual ROIC without goodwill** 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 The majority of industries had median ROICs between 9% and 12% ROIC varies by industry, whereas industry performance is quite stable. Therefore, industry membership can be an important predictor of forecasted performance.

6. 5 ROIC Segmented by Size and Revenue Growth Source: Compustat, McKinsey & Company’s corporate performance database 5.26.06.5 3.37.0 8.07.78.08.19.1 8.99.39.69.510.3 10.810.911.210.911.8 11.911.111.711.511.9 11.8 12.411.6 <0% 0-5% 5-10% 10-15% 15-20% >20% 3-year real growth rate <200 M 200- 500 M 500- 1,000 M 1,000- 2,500 M >2,500 M ROIC increases with higher growth rate No clear relation between size and performance Revenues Annual ROIC without goodwill, 1963-2003 Percent ROIC appears to be positively correlated with revenue growth, but has no relation to size. 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). Size shows no clear relation with ROIC. Efficiency gains from scale may be outweighed by bureaucratic inefficiencies or other inflexibilities.

7. 6 ROIC Decay Analysis: Non-Financial Companies Source:Compustat; McKinsey & Company’s corporate performance database Median ROIC of portfolio* Number of years following portfolio formation ROIC Percent >20 15-20 10-15 5-10 <5 ROIC demonstrates a pattern of mean reversion. Companies earning high returns tend to gradually fall over the next fifteen years and companies earning lowreturns 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. Percent At time 0, companies are grouped into one of five portfolios, ranked by their current ROIC

8. 7 ROIC Decay Analysis: Consumer Staples Industry Source:Compustat; McKinsey & Company’s corporate performance database Median ROIC of portfolio* Number of years following portfolio formation ROIC Percent >20 15-20 10-15 5-10 <5 Percent At time 0, companies are grouped into one of five portfolios, ranked by their current ROIC 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.

9. 8 ROIC Transition Probability (1994-2003) Source:Compustat; McKinsey & Company’s corporate performance database ROIC in 1994 ROIC in 2003 <5 5-10 10-15 15-20 >20 <55-1010-1515-20>20 Total 100 43% of companies with ROIC of < 5% in 1994 still have an ROIC of < 5% ten years later 50% of companies with ROIC of >20% in 1994 still have ROIC of >20% ten years later Companies with ROIC’s between 10% and 20% show little persistence, landing in any group with an equal probability Transition probability analysis confirms that ROIC shows considerable persistence, especially at high and low ROIC performance levels

10. 9 Empirical Analysis of Corporate Growth KEY FINDINGS 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). 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.

11. 10 Revenue Growth Over Time: Non-Financial Companies Source:Compustat; McKinsey & Company’s corporate performance database Median revenue growth demonstrates no trend over time. Beginning in 1973, ¼ of all companies actually shrank in real terms in a given year. 3-year rolling average of real revenue growth CAGR Percent 15.4 6.3 -0.2 Percent 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.

12. 11 Revenue Growth by Industry Group Source:Compustat; McKinsey & Company’s corporate performance database 1963-2003 Annual real revenue growth (%)** 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 Real revenue growth varies dramatically by industry. Unlike ROIC, rankings of industries based on growth vary over time.

13. 12 Revenue Growth Decay Analysis Source:Compustat; McKinsey & Company’s corporate performance database Revenue growth Percent >20 15-20 10-15 5-10 <5 Median growth of portfolio* Number of years following portfolio formation Percent Growth decays very quickly; for the typical company, high growth is not sustainable. By year five, the highest growth portfolio outperforms the lowest-growth portfolio by less than 5%. Although ROIC is persistent (high ROIC companies often continue to generate high ROIC), growth is not.

14. 13 Average Revenue Growth Rate for the Fortune 50 Source:Corporate Executive Board, “Stall Points: Barriers to Growth for the Large Corporate Enterprise”, 1998 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)! Before entrance to Fortune 50 After entrance to Fortune 50 Average annual real revenue growth rate (%) -5-4-3-20123456789101112131415 Years from entrance into Fortune 50 15.0 9.5 9.0 13.5 20.0 28.6 2.0 1.4 -0.7 0.7 1.2 0.1 2.1 2.8 5.1 4.5 -1.6 -0.1 -3.9

15. 14 Revenue Growth Transition Probability (1994-2003) Only 21% of companies with 20% or greater revenue in 1994 have at least 15% revenue growth ten years later Revenue growth in 1994 (%) Revenue growth in 2003 (%) <5 5-10 10-15 15-20 >20 <5 100 5-1010-1515-20>20Total Over 50% of companies in each revenue growth category in 1994 had <5% revenue growth ten years later 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.

16. 15 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. Closing Thoughts