Class 10(a) Valuation: Growth & Terminal Value
Class 10(a) Valuation: Growth & Terminal Value
Is there such thing as sustainable growth?
We’ll conclude our discussion on growth in this class.
Recap from last week's class on using analysts’ estimates, we know that they are somewhat dependable because they know more than we do.
So, the question is, do they actually know more?
Consider the following statements where there’s a problem with analysts’ growth estimates:
Growth is estimated in EPS. You’ll also need growth in operating income or revenue
Growth rate has a high correlation with historical growth
Is not really a good estimate of future growth
If you use analysts’ growth rate, is not really your intrinsic value of the company
All of the above
Fundamental Growth
Suppose a company reports an after-tax operating income of $75 million from an invested capital of $1 billion. Thus, generating an ROIC of 7.5%.
It doesn't intend to invest more with new assets and current assets will continue to generate ROIC of 7.5%. What follows?
Company doesn’t grow
Company doesn’t grow in the short term
Company doesn't have sustainable long-term growth
Company will shrink
Now, how would a company grow? 2 ways:
Reinvestment growth - by reinvesting the $75 million back with more assets
Efficiency growth - by making more than $75 million and thus ROIC >7.5%
Between the 2 ways, efficiency growth is preferred because it doesn’t involve re-investing cash back into the business which may or may not generate the same ROIC.
However, efficiency growth has a ceiling, you can’t be better than 100% efficiency. Hence, it doesn’t make sense to grow forever by saying the company is very efficient.
Eventually, you’ll need to reinvest.
So, say you improve ROIC from 7.5% to 10%. Your profit for the year will be $100 million. This is a growth of 33%, without any re-investment.
// Class 10 begins
3 variations from estimating fundamental growth
In earlier classes, we have been taught if we want to value the entire firm or only the equity of the firm.
1. EPS & Retention Ratio
If equity, do we look at Earnings Per Share (EPS)? Or do we look at Free Cash Flow to Equity?
How we think about how much we re-invest, and how well we re-invest is determined by what metrics we use.
In EPS, we measure reinvestment with “1-Payout Ratio”, which is the Retention Ratio or how much the company is preserving its EPS after the dividend. Say the company pays 40% of its earnings as dividends, this is the Payout Ratio.
We can then conclude the Retention Ratio is 60%, or how much it reinvests.
How well it reinvests is measured by Return on Equity (ROE) = Net Profit / Book Value of equity.
In the best-case scenario of the above, the company doesn’t pay dividends and has a 100% Retention Ratio. That’s it; if the company made $10 in EPS, it could only invest $10 back. This is the maximum based on this approach.
However, companies can invest more than $10, or more than 100% of the Retention Ratio by raising capital. Conversely, not paying out dividends doesn’t mean it is not investing as well as the company can hoard the cash!
Thus, we look at the following, how much is actually reinvested?
It can be easily measured. We look at Net Capex, change in working capital & change in debt level to know how much an equity investor is putting back into the company.
2. Net Income & Equity Reinvestment Rate
An Equity Reinvestment Rate is the above measurement, divided by Net Income. Formula as below.
Equity Reinvestment Rate = (Net Capex + Change in non-cash WC - Change in Debt) / Net Income
How well is this reinvested in thus measured by your operating assets or non-cash ROE.
It’s important to strip out the cash component because cash can also give an ROE, especially in the past 12 months (of 2023).
Non-cash ROE = (Net Income - Interest Income from cash) / (Book value of equity - cash)
3. Operating Income & Firm-wide Reinvestment Rate
Now let’s switch to Free Cash Flow to Firm where you use % of After-tax Operating Income to put back into the business.
Reinvestment Rate = (Net Capex + Change in non-cash WC) / After-tax Operating Income
The little difference between this method & the previous method is the absence of subtraction of debt, meaning all capital providers are included.
This means we need to look at the returns to all capital providers in measuring how well we re-invest.
Return on Invested Capital (ROIC) becomes the measurement.
ROIC = After-tax operating income / (Book value of equity + Book value of debt - cash)
Sustainable growth rate
What is the forever growth rate of a company?
Using EPS method & assuming ROE maintains throughout:
Growth = Retention ratio * ROE
In 2008, just before GFC, Wells Fargo's growth rate was 7.97% when their ROE was 17.56% & retention ratio was 45.37%.
This metric is almost the same for most banks during that time. Was it sustainable?
We all know the answer.
More so after GFC, regulation has mandated higher capital requirements for banks. All else equal, ROE will fall due to this.
Hence, fall in expected growth.
Understanding this formula means you can hack it.
To increase growth is to increase ROE. To increase ROE, use more debt!
Every real estate developer knows how to do this. As long as the project return is higher than the cost of debt, which is very achievable.
We can break ROE further to include the leverage component here:
ROE = ROIC + D/E (ROIC - interest(1-tax))
Using an example in the 1990s:
Ambev, have an extremely high ROE of 30.9%, partly because it borrows money a a rate that is below ROIC.
Its debt/equity was at 77%, with an ROIC of 19.1% and after-tax cost of debt of 5.6%.
Sounds good right? There’s another shoe waiting to drop.
The cost of equity will be much higher as reflected in the Levered Beta calculation. Which in turn, will lower the equity valuation.
Moving up from EPS to Net Income especially since a company can re-invest more than the retention ratio. We use the actual reinvestment amount net of debt.
Growth = Equity Reinvestment Rate * non-cash ROE
We use Coca-Cola as an example back in 2010:
Non-cash Net Income = $11,809 - $105 = $11,704 million
Non-cash Book equity = $25,346 - $7021 = $18,325 million
Non-cash ROE = $11,704 / $18,325 = 63.87%
This ROE seems extremely high!
That’s because Coca-Cola is a marketing company after they split their capex bottling company away. Hence, we should actually include advertising & marketing expenses in the ROE calculation, which would pull down ROE to a reasonable range.
When we visited the cash flow statement, their accounting CAPEX was $2,215 million, depreciation of $1,443 million & an increase in working capital of $335 million. Their debt also increased by $150 million in the same year.
Their equity re-investment is thus $2,215 - $1,443 +$335 - $150 = $957 million
Dividing this by $11,704 million would yield a reinvestment rate of 8.18%
Using the Growth formula above = 8.18% x 63.87% would give 5.22% growth.
This growth number will definitely be more believable if we adjust the advertising & marketing costs.
We now move on to the 3rd approach that uses ROIC.
Growth = ROIC * Reinvestment Rate
We demonstrate this using Cisco where the value 100x during the 90s through M&As.
In 1999, their fundamentals were as follows:
Reinvestment rate = 106%
ROIC = 34%
Expected growth in EBIT = 106% x 34% = 36%
As an investor, what should we be worried about?
Overstated ROIC?
Reinvestments mostly from acquisitions?
Growth in such a way is unsustainable, their ROIC drops eventually to single digit over the next decade as they grow bigger.
Is ROIC the holy grail? Not really as it is still based on accounting numbers. Below are the pitfalls.
In conclusion, sustainable growth works if you assume things are in a steady state. It is therefore more suitable for mature companies if we expect the margins & ROIC not to change.
/ / end of Class 10(a) Valuation