Companies are launching all kinds of “nontraditional” initiatives to digitize products and processes or to address looming environmental, social, and governance (ESG) concerns. In these instances, it’s critical to understand whether companies can achieve and sustain both high returns and low costs of capital in the long run. Finance fundamentals tell us this does not make sense.
Consider a company with a cash flow of $100 million, growing at 2 percent in perpetuity, with a 10 percent cost of capital. This company would be worth $1.25 billion today—equal to $100 million divided by 8 percent (10 percent minus 2 percent). If the company performs according to expectations and delivers 2 percent annual growth in cash flows, investors will receive exactly 10 percent a year of their initial investment as a return.1
Now let’s assume that the company takes some action and the cost of capital drops by half of a percentage point. The company would see a jump in value to $1.3 billion—equal to $100 million divided by 7.5 percent (9.5 percent minus 2 percent). If we assume that this additional value recognition is realized within a year, the company would see a 6.6 percent higher return to investors that year (equal to the additional capital gain of $83 million on the initial investment of $1.25 billion). In each of the following years, however, the company would return 9.5 percent to investors if it performed according to expectations—less than it did before. As a company’s cost of capital decreases, returns to investors are higher in the short term but lower in the long term.
Why do we often see claims that both higher returns and a lower cost of capital can be achieved simultaneously? That's probably a function of the data used to support these statements. Rarely is the same database used for both sides of the analysis, and historical data reveal only part of the story: if a company took some strategic action two years ago and saw a drop in the cost of capital, a regression today will show historical outperformance. However, going forward, the company probably won’t see higher returns, all else being equal.
When executives make decisions about investments in nontraditional initiatives, they generally should not over-index on potential discounts on the cost of capital from individual initiatives. Instead, they should consider how their overarching digital, ESG, or other strategies can create higher cash flows from increased revenues, productivity, and capital efficiencies; from reduced costs and risks; or from any combination of these. The impact in those areas will overwhelm any small cost-of-capital effects.
1. At the end of the first year, the company would be valued at $1.275 billion, equal to $102 million divided by 10 percent minus 2 percent. A capital gain of $25 million plus a cash flow of $100 million amount to an investor return of $125 million on a $1.25 billion investment at the beginning of year one. That equals 10 percent.
David Kohn is a senior knowledge expert and associate partner in McKinsey’s New York office, where Vartika Gupta is a research science expert. Tim Koller is a partner in the Denver office. Werner Rehm is a partner in the New Jersey office.
For a full discussion of this topic, see Tim Koller, Marc Goedhart, and David Wessels, Valuation: Measuring and Managing the Value of Companies, seventh edition, Hoboken, NJ, Wiley Finance, 2020.