McKinsey's First Principles of Valuation
Our key 10 takeaways from the TIP interview with Tim Koller
This week, Tim Koller was interviewed by The Investor’s Podcast (TIP). Koller co-authored our favorite book on corporate finance and financial markets titled “Valuation: Measuring and Managing the Value of Companies”. In fact, we’ve repeatedly labeled it The Financial Bible.
Let’s elaborate on our 10 key takeaways from this very recent interview, as well as provide additional color on how we evaluate shareholder value creation. We highly recommend taking the time to listen to the whole discussion.
We’ve already published blogs and presentations on this topic, but McKinsey’s insights are yet another layer to let this concept sink in.
1️⃣ Value of a Company is a Function of Two Metrics
The interview started with one of the most fundamental takeaways in understanding a company’s underlying value:
If you have two fast-growing companies, let's say they're growing at the same rate, but one of them has a higher return on capital, it won’t have to invest as much in order to achieve that revenue growth and that profit growth. As a result, it'll generate more cash flows and it should be worth a lot more.
That is why, for example, some slow-growing companies like consumer packaged goods companies have fairly high valuations, not because they're growing fast but because they have high returns on capital. I think there's a big misconception that a company's valuation multiple (like PE or enterprise value to EBITDA) is a function of growth. It's clearly a function of both growth and return on capital. - Tim Koller
As can be read in the book’s introduction, return on capital should exceed the company’s cost of capital:
Companies thrive when they create real economic value for their shareholders. Companies create value by investing capital at rates of return that exceed their cost of capital. These two truths apply across time and geography.
What we appreciate most about McKinsey’s research is that’s focused on findings and principles that have stood the test of time, and therefore, will be equally relevant over the next years/decades. Put another way, they’re statistically significant across all time frames and geographies.
This is evident in the updated versions of the Valuation book, where newly added paragraphs and/or refinements were related to changes in accounting standards (e.g., adoption of on-balance lease assets and liabilities) and emerging trends such as artificial intelligence and the increased relevance of intangible investments.
2️⃣ The Market Will Figure It All Out
Over the long run, you’d expect markets to reflect a company’s intrinsic shareholder value creation, while short-term moves are predicated on noise and/or a company’s quarterly optimization toolkit.
Choices of accounting methods, in the end, all flesh out in terms of eventually translating into cash flows. Don’t focus on the short-term share price, although for the most part, we find that the real short-term share price does reflect the economics of the company. - Tim Koller
One of the elements we’ve talked about in previous blogs is the usage of leasing.
It can really distort the ROIIC calculation, especially if one looks to compare US vs. European retailers on an EV/EBITDA basis. Under US GAAP, operating lease expense (including interest) is already reflected in EBITDA (i.e., it’s treated as an operating cash expense).
Conversely, under IFRS-16, the accounting changes for leases were now being reflected through depreciation and interest expense, and EBITDA increased. Supposedly, “true” cash expenses decreased, which is of course nonsense. If you’d compare Ahold Delhaize to Kroger, looking at EBITDA for valuation purposes yields different results. In the end, though, reconciled free cash flow is the only thing that matters.
3️⃣ Surrounding Yourself with the Right Shareholder Base
Many investors would disagree with the below and hope for as many short-term focused investors as possible who’ll offer them compelling buying opportunities. Volatility equals opportunity.
In our research, what we found and what we encourage our corporate executives (the CEOs and CFOs) to do is to focus on the investors that matter. Our research suggests that the investors that matter are long-term, intrinsic investors. There’s a lot of noise that CEOs, CFOs, and their boards face coming from the market. - Tim Koller
However, the reality is that, for the most part, really elevated and idiosyncratic volatility reflects investors’ doubts on underlying shareholder value creation, and a situation where they’re drastically over-paying or under-paying for the company’s intrinsic value. It’s black or white: a make or break.
Over multiple decades, shareholders of AutoZone have been served very well by the company’s steady growth recipe, and with relatively scarce periods of negative yearly returns. For most investors, it should have been much easier to hold onto AutoZone versus cyclical companies or fancy growth companies.
They simply didn’t have to chase the latest hot idea to compound their capital at an impressive >20% clip. Of course, that’s the past, but the fact that they’ve been doing it for close to 4 decades highlights the value of share prices moving in tandem with underlying intrinsic value. It doesn’t imply you can’t make money with cyclical companies; it just boils down to your timing and position sizing right. Trading execution vs. letting the companies compound our capital.
4️⃣ Meeting Short-Term Consensus vs. Striving for Maximum Long-Term Value Creation
Although we share our quarterly earnings recaps and letters, it’s important to recognize that the companies we own are playing the long game: most of their value creation will happen over the next decade. So, there’s no need to overreact to short-term quarterly swings. Perfecting your short-term EPS by cutting back on certain growth expenses (that would have a good short- to mid-term payoff) isn’t a good idea.
There are a lot of companies out there that will do whatever they can to meet the consensus. And when we asked investors about this, they said, “We don’t want companies taking artificial actions at the end of a period just to hit their numbers if it’s going to be a negative in the longer term. We don’t want companies cutting prices at the end of the quarter to sell something additional. - Tim Koller
The opposite is also through: targeted expense growth to enhance your market share potential profitably won’t likely please short-term oriented investors.
As an example, earlier this year, Harvia said it accelerated its Sales & Marketing expenses in Q4 2024, resulting in top-line performance exceeding analysts’ expectations, while margins were softer (if one could even call 17/18% EBIT a complete disaster).
But for us as management, there's a few things. One is the long term financial targets, and we strive to deliver or over deliver consistently. So that's kind of one point to take into account. The other one is that we feel that we are actually in a privileged position as a company. Many other companies are facing headwind in their core market.
Now, the thinking on our side is that how do we finance this increase in OPEX to drive growth in the future is by two means. One is solid top line growth and solid gross margin. So we can rest assured that we have a lot of attention on securing both as we move forward. Essentially, continue to drive growth and continue to drive solid gross margin so that we can keep the wheels running and keep developing our business for long term success. - Harvia’s CEO Järnefelt
Now, it’s tricky to assess SG&A returns, even more so from a long-term perspective. As quality growth investors, we’re looking for perpetual value creation, which means that, on balance, all investments should yield a satisfying return.
If we assume that the a near-term steady-state NOPAT margin at 18% - 19%, the decision to accelerate market share gains yielded a 0.7 million EUR in incremental NOPAT in just one quarter. That’s a 46.7% ROI on growth SG&A… Having a high ROIIC on regular CAPEX as well as flexing the SG&A muscle is what keeps the flywheel going.
In Q1 2025, profitability recovered strongly, while organic revenue growth excluding last year’s one-off promotions actually accelerated year-over-year and sequentially.
Both short-term ROIIC on tangible investments (growth CAPEX and working capital) and return on incremental SG&A spend are now pegged at >40%. It means you don’t need a lot of capital and/or time to grow your terminal intrinsic value beyond what the consensus is pointing to.
5️⃣ Real Value Creation: Not Through Share Repurchases
Contrary to popular belief, in of and themselves, buybacks don’t create shareholder value. They’re an excess capital allocation decision, and if you control for the quality factor and favorable timing, there is no meaningful alpha vs. shareholders reinvesting their dividends.
Timing could play a role as buybacks can be ramped up during sharp but short-lived share price corrections. Autonation has been an aggressive share repurchaser, but over the period FY11 till FY18, the stock didn’t go up as cash from operations didn’t grow materially, while its EPS increased >4x. ROIIC and growing the top-line and EBITA are the key factors to watch.
As Koller highlighted during the interview:
You want to focus on real value creation. Things like share repurchases are a return of capital; they're not additional value creation. You realize that they’re thinking long-term about generating real cash flow, not concerned about accounting or consensus or the impact of share purchases on EPS.
Personally, we prefer buybacks over dividends, as they’re tax-efficient. A valuation model is typically based on free cash flow before withholding taxes, so dividend taxes do play a role.
Once again, the fact that a dividend growth strategy generally outperforms the benchmark has nothing to do with the cash distributions themselves (it shouldn’t make you feel richer): dividends are a consequence of excess cash generation after accounting for growth, and management’s decision to distribute free cash back to shareholders.
Not giving excess cash back to shareholders means there’s the inevitable side effect of that cash losing time value, unless the management team is waiting for a sizable opportunity. Striking a balance between maintaining a fortress balance sheet and proactive excess management is what all successful compounders have or have had in common. Reinvesting excess cash in growth initiatives with poor returns is value-destructive, as discussed above.
You can perfectly grow your business, and pay out 30-50% in dividends and/or share repurchases, just because of very high ROIICs (returns on incremental invested capital) and cash IRRs (see below).
This is a much more favorable outcome versus a company paying out a sizable dividend of 6%, trading at 10x earnings, and making small reinvestments at an implied real (after inflation) ROIIC of <8% (typical cost of capital). That 6% dividend is a plaster on the wound for an investment that’ll be lagging other alternatives with higher growth, return, and actually, below-average risk.
6️⃣ Getting a Sense of the Operating Returns
Theoretically, ROIC (return on invested capital) is made up of NOPAT (net operating profit after taxes) and invested capital (including or excluding goodwill and other acquisition-related intangibles). NOPAT is based on cash taxes, but as we’ve clarified previously, we’d like to focus on the operating drivers.
The drivers are: profitability and asset turnover.
As Koller commented:
We want to focus on the things that you can really drive and that are pretty simple to understand, like inventories, receivables, payables, fixed assets, etc. So focusing on the operating performance is the most important thing. You don’t want to get hung up on things like how deferred taxes are driving your return on capital.
7️⃣ Business Unit Analysis
Something that’s not as simple as it may seem for publicly traded companies relates to business unit analysis.
The other thing that’s important when it comes to return on capital is not to look at it just, especially for a larger company, not to just look at it at the enterprise level. That really doesn’t tell you anything. It’s also very important to dive down into the units. - Tim Koller
Atlas Copco is one of very few companies that shares its ROCE by operating segment (e.g. Vacuum Technique).
Copart shares a high-level overview of the total assets, capital expenditures and EBIT for its geographic segments. It highlights that the international segment is still weighing on the aggregate profitability, asset turnover, and thus ROIC. Investors should then weigh the increased value (after accounting for the cost of capital) of international expansion vs. reinvesting in the US. Ultimately, value creation boils down to:
how much capital you redeploy;
at which rates (the underlying return, excluding effects of extraordinary inflation flowing through your profits and depreciation of long-term assets reducing the reported invested capital figure);
and for how long these growth investments will contribute? I.e. focus should be on cash IRRs instead of a point-in-time assessment of ROIC. More on that below.
8️⃣ Cost of Capital - Sanity Check
Cost of capital, cost of equity, capital structure… they all seem to dramatically influence a company’s valuation. At McKinsey, they don’t advocate increasing a company's leverage to lower its cost of capital. The risks associated with higher leverage, for instance reduced flexibility and potential difficulties in making future investments, generally outweigh any benefits. As a result, they downplay efforts to actively manage or alter the cost of capital, since there's typically not much that can be done about it anyway.
Your cost of capital is for the most part determined by the industry that you're in. And it is what it is. For most large companies, your cost of capital is somewhere between 7% and 12%. And yet your return on capital varies over a much broader range. We've typically been using a risk-free rate of 4-4.5%. Which is pretty stable and a market risk premium of about 5%. - Tim Koller
Similar to ROIIC, cost of capital and valuation is more about being reasonable than anything else, knowing that 80% or more of the total annualized shareholder return (TSR) comes from a company’s growth (underpinned by ROIIC) and excess cash returns to shareholders.
9️⃣ Using EBITDA: In-House Production versus Outsourcing
As we’ve seen in private small and-medium-sized M&A, there’s a huge emphasis on EBITDA. While it’s like an ideal gross/pre-tax cash flow, it tells you little about a company’s capital intensity.
Different companies have different asset profiles. For instance, if one company outsources its manufacturing while another does it in-house, the in-house manufacturer will have more depreciation on its books. If you ignore depreciation, you miss those differences in asset intensity. Yet they’re really using the same amount of equipment and factories; it’s just under someone else’s name. Similarly, we consider taxes because companies operating in different countries can have very different tax rates.
That’s why we prefer enterprise value over NOPAT. - Tim Koller
In this case, a very high ROIC may not make much sense, as it’s driven by a low capital base (given that you’re outsourcing your production). Total economic profit generation is then the key metric to analyze more carefully.
🔟 Longevity, Disruption, and Risky Bets
Finally, there’s a broad view that the lifecycle of companies, i.e. the average lifespan of firms from founding to exit, decline, or reinvention, has gotten shorter in recent decades. Four elements come to mind:
Technological disruption: advances in technology and digitalization have allowed new entrants to challenge established players more quickly. Incumbents that fail to adapt can fade rapidly.
Global competition: global markets create more pressure and competition, accelerating the need to innovate.
Changing consumer preferences: with information more accessible, consumers switch to better alternatives faster, shortening the dominance period of products and companies.
Access to capital: startups can get funding more easily, launch faster, and scale quicker, yet this also means more new competitors emerge constantly.
Tim Koller’s perspective (and McKinsey’s broader view) is that companies should be willing to invest in initiatives with uncertain outcomes, especially in an era where the average corporate lifecycle is getting shorter.
You do want to be making some risky bets. The important thing is not whether or not you should do it, but whether you’re truly committed to those risky bets. If you’re competing with a bunch of startups, that’s a big challenge for large companies. Often, companies have very rigid pay scales, so if you can’t compete or can’t attract the best talent, maybe you shouldn’t be making that bet. Another element about making these bets is whether they bring some sort of competitive advantage.
Final Remark - Our View on Longevity
To close out this blog, we’d like to share our view on longevity and how relevant ROIC and/or ROIIC really are.
As you likely know, we’re not technology experts, nor do we have a strong grasp on the returns for businesses that must spend heavily on customer retention. The rapid emergence and growing dominance of purely intangible businesses, which can quickly displace competitors, makes it much harder to apply the frameworks of ROIC and ROIIC. The same challenges apply to cyclical businesses.
A high ROIC tells you little about a company’s effective return on its growth investments. A rolling ROIC can be attractive, but we’re not interested in the accounting figure: the focus is on cash.
Hence, IRR is helpful to measure a company’s inherent project profitability. The Internal Rate of Return (IRR) is the discount rate that makes the NPV (net present value) of a project zero. If it’s higher than the company’s hurdle rate (under various scenarios), and better than an alternative investment, then the project investment should be undertaken as it creates incremental value.
With increased post-COVID cyclicality, a changing trade environment, focusing solely on ROIC isn’t enough to distinguish which companies are effectively creating shareholder value. It’s exactly what we’ve talked about in the below blog: ROIC cannot be used in isolation.
Valuation relies on assumptions and explicitly assumes ROIC and ROIIC longevity, which increasingly doesn’t add up with the trend of a shorter corporate lifecycle.
The more that I've learned the more I realize how little I know
Incredible distillation of timeless corporate finance principles. Tim Koller’s emphasis on capital returns, not just growth, cuts through the noise in today’s valuation-chasing market. The reminder that valuation is a function of both ROIIC and growth—especially in a world obsessed with topline metrics—feels more relevant than ever.