Valuation is often understood as a verdict handed down by the stock market: a number that rises and falls based on earnings announcements, investor sentiment, or headline multiples. But in truth, behind every valuation are fundamental choices about growth, capital allocation, time horizons, and trade-offs—choices that matter far more for long-term value than short-term market signals.
In this video Explainer, McKinsey’s Marc Goedhart, Susan Nolen Foushee, and Tim Koller draw on decades of research and client experience to explain how to actually value companies. They unpack what drives value creation over the long term, when growth helps—or hurts—valuation, the most common mistakes leaders make, and why focusing on the wrong metrics can quietly erode value. Along the way, they challenge some of the most persistent myths about earnings, cash flow, and the investors that truly matter.
This interview has been edited for length and clarity.
Why is value creation so important for companies?
Tim Koller: Value creation is so important for companies because the company’s shareholders have invested their capital in the company, and they expect a return on that investment. That’s the fundamental reason why value creation is so important.
Marc Goedhart: What we know from a lot of research and from our experience is that companies that focus more on value creation not only create more value for their shareholders but also tend to be more innovative and create more jobs.
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When companies maximize value creation for shareholders, they help allocate resources across the economy in the most effective way. So essentially, if companies focus on value creation, they also contribute to increasing wealth for society as a whole.
An example of an entire industry that has created enormous value for shareholders, but also huge benefits for society at large, is high tech—especially the American high-tech industry. Companies like Apple and Microsoft have not just made shareholders a lot richer, they have also driven innovation at scale and economic growth.
Susan Nolen Foushee: Beyond responsibility to investors, the factors that drive value creation—growth, profitability, and the efficient use of capital—are really important for the economic and organizational health of a company. Those factors, such as top-line growth and the effective use of resources, are really what’s going to make a company sustainable over the long run.
What are the fundamental drivers of a company’s valuation?
Tim Koller: The rule of thumb for CEOs thinking about the valuation of their companies is to focus on the ultimate drivers of value creation: revenue growth and return on capital.
Return on capital is simply the operating profits of the company divided by the amount of capital you’ve got invested in the company—fixed assets, working capital, et cetera. Those two measures will drive your cash flows, and ultimately, the value of a company is driven by its cash flows.
The advantage of focusing on return on capital and revenue growth is that these are strategic things you can debate. You can analyze whether you’re growing faster or slower than your peers, whether your return on capital is above your cost of capital, and whether it’s going up or down.
Marc Goedhart: The emphasis you need to put on return on capital versus growth depends on where you are as a company.
Companies that generate high returns on capital can actually generate most of their value by focusing on growth—by boosting the revenues they generate. That’s what you typically see in industries like pharmaceuticals and high tech, where margins and returns on capital are high.
In contrast, companies that have low returns on capital—which we typically see in very competitive industries such as airlines, telecoms, or chemicals—do not create most of their value by generating more growth. They create more value by improving the return on capital itself, by improving margins and improving capital efficiency.
That’s why you see companies in those industries focusing much more on cost management and capital efficiency than on improving growth.
Susan Nolen Foushee: Growth and return on invested capital are both really important in terms of the valuation of a company. Growth is obviously very important to bring cash into the company.
But ROIC captures two different uses of resources. One is operating margin: how profitable a company is. The other is capital efficiency, which means companies need to think about their assets, whether those are inventories or the capital expenditures they’re making in new stores or new factories.
Companies that don’t think about those are missing a chance to optimize their cash flow. So we ask CEOs and their teams to think about what’s going on with growth and what’s going on with ROIC, because those two factors combined drive cash flow, and cash flow is what eventually drives valuation.
Can growth erode value?
Tim Koller: If you grow earnings without earning attractive returns on capital, you might be destroying value.
It’s not that we ignore earnings. Earnings are important. But if you do a good job with return on capital and revenue growth, you will also generate attractive earnings growth.
Marc Goedhart: It’s not just profit maximization or maximization of EBITDA. That is insufficient. You really need to make sure that you combine the concept of profit—EBITDA, EBIT, or EBITA—with the amount of capital that’s being deployed.
There are risks for executives who, faced with very high valuation levels, may become overenthusiastic about investing and acquiring. The danger is investing far too much capital in businesses that do not have very attractive long-term perspectives but seem attractive because valuations were high.
An example of this is what we saw in 2000 and 2001, with the first internet boom and bust. We saw quite a few companies valued at very high levels that were ultimately hard to reconcile with long-term growth and long-term returns on capital.
Susan Nolen Foushee: When companies earn returns on capital that are less than the cost of capital, even though there may be profits coming in, over time, that will destroy value.
We see this sometimes with retailers that build many stores or industrial companies that overbuild their factories. Even though there may be profits coming in from the products sold or manufactured, cash flows are weighed down because the investments are so high.
That’s why we ask people to think beyond metrics such as earnings per share and really think about ROIC, because it helps bring a spotlight to an important issue that might otherwise be overlooked.
What are the biggest mistakes companies make when thinking about valuation?
Susan Nolen Foushee: One mistake companies make when they think about their valuation is overemphasizing valuation multiples.
Often, they will look at a peer that has the highest multiple and decide, “We must be undervalued relative to that company.” But the question they should be asking is why.
Maybe that peer is exposed to higher-growth segments in the industry. Or maybe your own valuation is lower because your investors have yet to see the benefits of announced transformation programs or synergies.
It’s really important to look at your own performance with an objective eye and think, based on what investors can see about my current performance and realistic improvement, what value should I deserve—rather than quickly deciding you’re undervalued just because you don’t have the same multiple as a peer.
Tim Koller: Often, CEOs will complain that their shares are undervalued, particularly relative to their peers. When you dig deeper, you often find that they’re comparing themselves to the wrong peers. Or they’re comparing themselves to aspirational peers—whom they aspire to be like, rather than who they actually are. When we look at companies in the same industry that are performing the same as you in terms of growth and return on capital, we find that the valuation discount often disappears.
When you compare companies with similar performance, you often find that the valuation discount disappears. It’s very rare that companies are truly undervalued once you take performance into account.
Marc Goedhart: One of the biggest mistakes we see companies make is that they do not focus on return on capital, but instead focus on EBIT or EBITDA.
Many companies understand that both growth and profit are important. But very few companies include the capital dimension when thinking about value creation. Focusing exclusively on boosting EBIT or EBITDA without considering the amount of capital required means you’re not focusing sufficiently on value creation.
Another common mistake is that companies look at multiples rather than discounted cash flows. Multiples are not a good guide for understanding what companies need to do to improve value creation for shareholders.
Thinking through exactly how new investments or acquisitions affect the discounted cash flow of your company—by understanding how they affect future cash flows and the cost of capital—is key.
And finally, companies can be naive about what shareholders actually care about. Shareholders are not interested in higher net profits or earnings per share. They are interested in what fundamentally drives the value of a company and whether improvements in cash flows will last.
Why does cash flow matter more than earnings or earnings per share?
Marc Goedhart: What really drives the value of a company is not the next couple of years of earnings or growth or even return on capital.
It’s really about the longer-term pattern of cash flows—five years, seven years, and beyond—as captured in returns on capital and growth.
Managers should be aware that it’s not about this year’s earnings per share [EPS], not about this year’s EBITDA, not even about this year’s return on capital and growth. It’s really about the long term.
Companies should not refer to decisions or actions that lead to lower value in the long term just to improve their earnings for the next 12 months or for the next quarter.
Susan Nolen Foushee: One mistake CEOs and their teams can make is getting too focused on earnings per share as a specific metric. Companies can get really tangled up here; we urge them to take a bigger-picture view.
EPS is not a metric that reflects cash flow because it is not impacted by capital expenditures, so it doesn’t capture the capital-efficiency lens of value creation. It can also be affected by a variety of nonoperating factors, such as extraordinary items or interest expense, which makes it hard to compare with other companies.
Our research shows that investors see through EPS as a metric, particularly the intrinsic investors who really move share prices.
Tim Koller: Many companies feel pressure to achieve short-term profits, and they often blame that pressure on the stock market.
As a result, you see companies passing up attractive investments because they don’t generate profits right away.
I know one company that had a rule that every business unit had to increase its profits faster than its revenues. They had business units with very high 30 percent profit margins and very high 40 or 50 percent returns on capital. This created an incentive for managers to pass up growth opportunities that might have earned only 25 percent margins—which most companies would love to have. So this company went from being one of the more innovative companies 20 years ago to struggling today. They’re so short-term oriented that there’s no longer any growth.
Marc Goedhart: When communicating with investors, companies should be aware that not all stock market participants are equally sophisticated.
What they should try to find out is which of their shareholders are what we would call intrinsic investors—investors that focus on the long term and are truly interested in the underlying quality of the business and long-term outlook for the markets the company operates in.
Those investors are the ones who, in the long term, will set the share price for a company. They are also the investors you can have a meaningful dialogue with as an executive, because they are informed about the business and the market you’re operating in.
That is in contrast to other investors, such as index trackers, who may hold large stakes simply because a company is part of a market index. What you say in an earnings call or capital markets day presentation is not going to change their position in the stock.
Susan Nolen Foushee: Some companies tend to think that the stock market is naive, and that investors will overfixate on one metric or one earnings call.
What our research shows is that the investors that matter are the intrinsic investors, those focused on long-term performance, including cash flow generation, and less bothered by a single quarter where earnings per share might be lower because of, for example, transformation costs.
Sometimes you’ll see a short-term reaction in the stock market right after an earnings call. But often, several days later, you’ll see a course correction. That’s why we urge managers to hold steady and think about the longer term, rather than managing the business to minute-by-minute fluctuations in the stock price.
Tim Koller: We find that many companies believe they are under pressure from the stock market to be short-term oriented, but in reality, there are plenty of investors who are long-term oriented. They’re just not the noisiest investors.
Often, the pressure to focus on the short term has more to do with internal factors, such as the compensation of the CEO or whether the board fully understands the decisions the company is making.
Companies can be more long-term oriented by doing a better job of allocating their existing resources across different product lines or initiatives. We see that companies are too static in how they allocate resources. They continue to invest in legacy businesses because of inertia, rather than reallocating capital and people toward businesses and initiatives that have better value creation opportunities.
That creates a big opportunity for companies to be more long-term oriented without necessarily spending more money—simply by moving resources away from areas that are not going to create value and toward those that are.
