3. Capital intensity: what growth really costs

Level 2: The value drivers

You now have two drivers: how much sales grow and what margin the additional euro leaves. Plenty of people would call the valuation done at that point. It would be an expensive mistake, because the question that separates the businesses which make their owners richer from the ones that merely keep them busy is still missing: how much money has to go in to achieve that growth.

Growing is not free, and it is almost never cheap

When a company sells more, it needs two things first. The first is working capital: inventory to make or buy before selling it, and invoices waiting to be collected while the customer takes its sixty days. The second is fixed investment: more machines, more shops, more trucks, more data centers.

Both come out of the cash box. Neither shows up as a cost in the profit and loss account for the year the money goes out: working capital never appears at all, and fixed investment is spread across years in the form of depreciation. That is how a company can report rising profits and not have a euro available.

Incremental capital intensity

The number that sums all of this up is easy to state: how many cents of additional investment, between fixed assets and working capital, have to be committed for every additional euro of sales. It is the third value driver, and it is the one most amateurs do not even look at.

Working capital can be estimated with a direct calculation. Take a company with sixty days of inventory, forty-five days to collect from customers and thirty days to pay suppliers. Its cash conversion cycle is sixty plus forty-five minus thirty, that is, seventy-five days. If it increases sales by 100 million, the equivalent of seventy-five days of those sales is tied up: 100 times 75 divided by 365, some 20.5 million that leave the cash box and do not come back for as long as the company keeps operating at that size.

There are businesses where the sign flips. A supermarket collects in cash and pays its suppliers at ninety days: its working capital is negative and growing frees up cash rather than consuming it. The same goes for subscriptions billed in advance. It is an enormous financial advantage that appears in no margin at all.

Two identical companies that are not worth the same

Here is the calculation that sums up the module. Two companies turn over 1,000 million, grow 10% and make an after-tax operating profit of 10% on sales. Identical on the first two drivers.

• Company A needs 20 cents of capital for every additional euro of sales. On 1,100 million of sales, its after-tax operating profit is 110 million. Sales have risen by 100, so it invests 20. That leaves it 90 million of free cash.
• Company B needs 50 cents per euro. Same profit of 110 million, but it invests 50. That leaves it 60 million.

A generates 50% more cash than B with exactly the same growth and exactly the same margin. And if you value both as a growing perpetuity, with a cost of capital of 8% and growth of 4%, A is worth 90 over 0.04, that is, 2,250 million, and B is worth 60 over 0.04, that is 1,500. A 50% difference in value between two companies that look like twins in the profit and loss account.

Take the example to its extreme: if a company needed 1.10 euros of investment for every new euro of sales, its growth would leave absolutely nothing behind. It would grow, it would make the headlines, and it would not produce a single cent for its owners. Bruce Greenwald puts it bluntly: growth only creates value when what you earn on invested capital exceeds what that capital costs. Below that line, growing destroys.

Why free cash flow is discounted rather than profit

With this in hand, the rule that looked like an arbitrary convention in the previous level makes sense. What gets discounted is free cash flow, which is after-tax operating profit minus the investment needed to sustain and grow the business, for three concrete reasons:

• Profit does not capture working capital. A company can double its profits while drowning in the financing of inventory and customers.
• Depreciation is not investment. It spreads the cost of assets bought in the past, at past prices; what leaves the cash box today can be twice as much.
• The owner can only take out what is left over. The rest is not theirs: it is working inside the business so that it carries on existing.

A real case: the same industry, two opposite intensities

Semiconductors teach this better than any other sector, because two radically different models live side by side within it.

A manufacturer that owns its own plants invests enormous sums. In 2023 the world's largest contract manufacturer turned over something like 69,000 million dollars and invested of the order of 30,000 million in fixed assets: close to 40% of its sales going into building capacity. Every point of growth demands steel, clean rooms and lithography equipment bought years before anything is sold.

A fabless design company, which subcontracts the manufacturing, operates at the other extreme: its annual investment in fixed assets is a very small fraction of its sales, because somebody else puts up the heavy capital. The same euro of growth costs it a tiny share of what it costs the manufacturer.

None of this means one model is a better investment than the other: the manufacturer has barriers to entry the designer does not have, and those barriers are worth money too. It means that the same growth and the same margin produce different values, and that ignoring the third driver is valuing blind. A teaching example, not a recommendation.