Question regarding Constellation / Topicus / Lumine

[Tintin]

In the 2009 President's Letter, Mark Leonard said that a focus on ROIC plus organic growth is a better way of looking at the true change in shareholder value over time because a VMS business can achieve incremental growth without corresponding incremental capital, as well as the fact that the intangibles acquired are not losing their value.  I'm fine with that conceptually, but have a problem.  To me it seems like using the ROIC plus growth overestimates the change in shareholder value because the organic growth is already captured in the ROIC.  It's like having your cake and eating it. 

 

Let's go through the math in a very simple way and someone can hopefully point out where I'm going wrong.

 

Imagine a VMS company produces $100 of NOPAT based on $500 of invested capital for a 20% ROIC.  If we assume a 10% cost of capital and use a perpetuity formula, that means the company should be valued at $1,000.  

 

Let's assume that after implementing the Constellation playbook, the following year organic revenue grows by 10%.  If margins are unchanged then NOPAT increases to $110 based on the same invested capital of $500 the prior year, for an improved ROIC of 22%.  If the cost of capital remains 10%, and we assume that this growth is a one-time boost from following the 'pricing for value' playbook, then the company would be valued at $1,100 using a perpetuity formula once again.

 

In this scenario, the value of the company has increased by 10%.  But using the Constellation formula we arrive at 32%!  ROIC (22%) plus organic growth (10%) = 32%.

 

From my perspective, the increase in shareholder value appears to be more than adequately captured by looking at the growth of ROIC alone, which is 10% (the same difference that our PV formulas produced).   After all, the increase in organic revenue growth is already captured by the higher numerator in year 2.  Adding organic revenue growth to ROIC appears to significantly overstate the change in shareholder value, but that is what Mr Leonard appears to be suggesting.

 

It's clear there must be a flaw in my thinking because of the reverence in which Mark Leonard's letters are held by a large number of people within the investment space.  But I can't get my head around where I'm going wrong.

 

Thanks. 

[KCLarkin]

First, this method is only valid for CSU (and spins). This is not a general truth for VMS.

 

You seem to be missing what happens to the "R" in ROIC.

 

Try running the numbers again in a situation where the organic revenue growth requires zero additional capital. And 100% of the FCF is "reinvested" in M&A.

[Eldad]

12 hours ago, KCLarkin said:

First, this method is only valid for CSU (and spins). This is not a general truth for VMS.

 

You seem to be missing what happens to the "R" in ROIC.

 

Try running the numbers again in a situation where the organic revenue growth requires zero additional capital. And 100% of the FCF is "reinvested" in M&A.

Yes. Cost of capital on the organic is 0 or even negative as the years revenue is prepaid upfront. 

[Eldad]

19 hours ago, Tintin said:

In the 2009 President's Letter, Mark Leonard said that a focus on ROIC plus organic growth is a better way of looking at the true change in shareholder value over time because a VMS business can achieve incremental growth without corresponding incremental capital, as well as the fact that the intangibles acquired are not losing their value.  I'm fine with that conceptually, but have a problem.  To me it seems like using the ROIC plus growth overestimates the change in shareholder value because the organic growth is already captured in the ROIC.  It's like having your cake and eating it. 

 

Let's go through the math in a very simple way and someone can hopefully point out where I'm going wrong.

 

Imagine a VMS company produces $100 of NOPAT based on $500 of invested capital for a 20% ROIC.  If we assume a 10% cost of capital and use a perpetuity formula, that means the company should be valued at $1,000.  

 

Let's assume that after implementing the Constellation playbook, the following year organic revenue grows by 10%.  If margins are unchanged then NOPAT increases to $110 based on the same invested capital of $500 the prior year, for an improved ROIC of 22%.  If the cost of capital remains 10%, and we assume that this growth is a one-time boost from following the 'pricing for value' playbook, then the company would be valued at $1,100 using a perpetuity formula once again.

 

In this scenario, the value of the company has increased by 10%.  But using the Constellation formula we arrive at 32%!  ROIC (22%) plus organic growth (10%) = 32%.

 

From my perspective, the increase in shareholder value appears to be more than adequately captured by looking at the growth of ROIC alone, which is 10% (the same difference that our PV formulas produced).   After all, the increase in organic revenue growth is already captured by the higher numerator in year 2.  Adding organic revenue growth to ROIC appears to significantly overstate the change in shareholder value, but that is what Mr Leonard appears to be suggesting.

 

It's clear there must be a flaw in my thinking because of the reverence in which Mark Leonard's letters are held by a large number of people within the investment space.  But I can't get my head around where I'm going wrong.

 

Thanks. 

In the first year, I see your point. Organic is already included in ROIC. 
But imagine this:

1. 100 of capital

2. 20% ROIC 

3. 10% organic with no additional cost of capital 

4. All income is dividend out every year

 

Year 1 22 of income. 22% ROIC

Year 2 24.2 of income 24.2% ROIC

Year 3 26.6 

Year 4 29.26

 

When you put that into a DCF it is pretty powerful for the intrinsic value. Not sure exactly sure how it equates to ROIC + Organic every year but it’s definitely not double counting as it compounds. Maybe it does assume reinvestment of all income as well. I am guessing ML proved it out arithmetically. 

 

[sholland]

6 hours ago, Eldad said:

Maybe it does assume reinvestment of all income as well. I am guessing ML proved it out arithmetically. 

 

Yes, it does assume that all FCF is reinvested.  See 2017 President’s letter.