The base model
You may be surprised by the 20 per cent return (ROI) shown in Table 2.2, but this (before tax and interest) is often achieved by Anglo-Saxon companies (more on this topic can be found in Chapter 7).
TABLE 2.2 ROI textbook figures
The 10 per cent profit margin is an average figure. Many businesses would be delighted with such a high margin, eg construction companies, whereas other businesses would find this unacceptably low.
The 2:1 asset turnover (sales to capital employed) again may seem very low - a whole year's sales (from the P&L account) in relation to what is needed as investment to deliver the sales. While this is a typical figure for many businesses, it is sector specific and can be quite different depending on 'strategy'. For example:
- If you are a 'utility' - telecoms, electricity generation - this figure may well be below 1:1 as a huge amount of capital employed is required to generate sales.
- If you outsource production, this will be a much higher ratio.
But let us accept the textbook figures for now. At this stage it is the messages on revealing strategies that matter.
An arithmetical proof of a high-return strategy
Before considering the drivers for making good returns further, let's look at the arithmetical outcome of delivering consistent returns. The delivery of consistent and high returns leads to the delivery of real shareholder value increases, as this model demonstrates.
The model shown in Table 2.3 assumes at the start: 100 is invested; a return of 20 per cent is made; 33 per cent of the annual profit is paid out as dividend (a return of 7 per cent to the investors); 67 per cent of the annual profit is reinvested in capital employed (acquisitions, new machines etc); and (unrealistically!) there is no taxation.
The assumption is that such investments will also generate 20 per cent returns. The model proceeds and the capital employed increases in a geometric progression until by year 7 the business has double the capital employed in the business (shareholder value) and investors receive a 14 per cent dividend on their original capital of 100.
So why does every CEO not deliver real growth in shareholder value? It is just a matter of arithmetic!
Well, the market, competitors or the economy may not allow a 20 per cent return, there may not be unlimited growth in sales, and capital invested may be invested unwisely.
It is the latter 'sin' that has undoubtedly most often been committed by CEOs over the years: 'We must grow - invest - capture market share etc' We shall
TABLE 2.3 High returns reinvested
look at the most important subject of investment or project appraisal later in Chapter 11. The importance of a thorough investment appraisal process, be it investment in other businesses or in plant and equipment, is to prevent value-destroying investment - maybe it should be called 'dis-investment'.