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Fundamentals of Value Creation

November 20, 2011 | About:
Rishi Gosalia

Rishi Gosalia

43 followers
Before I begin, let me give credit to where credit is due — the thoughts that follow below are not of my own but heavily borrowed from the book "Valuation: Measuring and Managing the Value of Companies."

Consider the following two hypothetical companies, Value and Volume, whose projected revenues and earnings are identical. Both companies earn $100 million in year one and increase their revenues and earnings at 5 percent per year in all future periods, so their projected earnings are identical. Assume that shares outstanding for both companies are the same, so projected EPS for both are also identical. Here is a question — are the two companies' values also the same, or in technical terms, do they deserve the same P/E multiple? The investment community's fixation with EPS growth and P/E multiples would make you believe it to be true, but let me dispel this myth here.

Future growth does not come for free. Both companies have to reinvest a certain percentage of their earnings for the year to achieve future growth. Let's assume that company Value has to invest only 25% of its earnings back into the business but Volume has to reinvest back 50% of its earnings to achieve the same rate of growth as company Value. Thus, company Value creates higher cash flows (earnings - investments into the business for future growth) relative to company Volume.

ValueDriver1.png

What remains for the shareholder are these streams of cash flows that she can expect to earn in future periods (through dividend payments for instance). Since "a bird in hand is worth two in the bush," you discount back (using the company's cost of capital) these future expected streams of cash flows to the current time and sum them up to get the intrinsic value for these two companies. Assuming that the cost of capital for both companies are the same, since company Value creates higher cash flows it is more valuable and deserves a higher P/E multiple than company Volume even though both have identical projected EPS in future periods.

I can't tell you how often I listen to analysts saying, "This company trades at 18x P/E and hence it is not cheap. Look at this other company that trades at 10x P/E — it is much cheaper." In an ideal world where all companies are required to put in same percentage of investment to achieve the same rates of future growth, it makes sense to make these types of comparisons, but otherwise it is totally nonsensical.

Company Value achieves 5% of growth each year by investing back 25% (also known as Investment Rate) of its earnings each year. The ratio of Growth / Investment Rate is known in the financial literature as ROIC (Return on Invested Capital). Thus, Value's ROIC is 20% and Volume's ROIC is 10%.

Let's look at the valuation matrix for a company that earns $100 million in year one, has a long-term growth rate of 2% to 4%, ROIC of 10% to 16%, and a cost of capital of 10%.

ValuationMatrix.png

A few observations — (i) the blue column shows that growth has no effect on value when ROIC is same as cost of capital, (ii) the two green cells show that a company with lower growth rate but higher ROIC can be just as valuable as one that has higher growth but lower ROIC, and (iii) the red cell shows that any growth below ROIC destroys value.

With this new (and correct) way of looking at a business, you will find the constant touting of EPS growth for such and such a company on CNBC to be completely worthless information, especially since CNBC does not talk about ROIC or cost of capital for the business.

Let's talk about how I calculated the valuation matrix above. First, I need to introduce a few new terms.

  • NOPAT (Net Operating Profit less Adjusted Taxes): represents profits generated from company's core operations after subtracting the income taxes related to the core operations
  • Invested Capital (IC): represents the cumulative amount the business has invested in its core operations - property, plant, and equipment, and working capital
  • Net Investment is the increase in investment capital from one year to the next
  • Free Cash Flow (FCF): is the cash flow generated by the core operations of the business after deducting investments in new capital. So, FCF = NOPAT - Net Investment
  • Return on Invested Capital (ROIC): is the return the company earns on each dollar invested in the business. So, ROIC = NOPAT / Invested Capital. ROIC can also be defined as the incremental return on new or incremental capital. However, for now we assume that both are the same. If not, then the later definition is known as RONIC (Return on New Invested Capital).
  • Investment Rate (IR) is the portion of NOPAT invested back in the business. So, IR = Net Investment / NOPAT.
  • Weighted average cost of capital (WACC) is the return that investors expect to make from investing in the enterprise and therefore the appropriate discount rate for FCF.
  • Growth (g) is the rate at which NOPAT and cash flow grow each year. Investing the same proportion of NOPAT each year also means that the company's free cash flow grows at rate g.
Since company's free cash flow grows at a constant rate g, we can begin valuing the company by using the well-known formula for perpetual growth:

Enterprise Value = FCF / (WACC - g) .........(1)

Next, lets define FCF in terms of NOPAT and IR.

FCF = NOPAT - Net Investment =>

FCF = NOPAT - NOPAT * IR =>

FCF = NOPAT * (1-IR) ..............(2)

In the section on Value vs. Volume, we had seen that

ROIC = g / IR =>

IR = g / ROIC ............(3)

so putting equation (3) and (2) in (1), you get

Enterprise Value = NOPAT (1 - g/ROIC) / (WACC - g)

If you put ROIC = WACC in the above formula, you get Value = NOPAT / WACC, a formula that is independent of g as we had seen in the blue column of the valuation matrix.

If you divide by NOPAT on both sides, you get:

Enterprise Value / NOPAT = (1 - g/ROIC) / (WACC - g)

The Enterprise Value to NOPAT ratio (the magic formula uses a similar ratio but it is pretax - EV/EBIT) is a more meaningful way of thinking about the appropriate multiple for a business instead of the usually quoted P/E multiple. As you can see, the key drivers of this multiple are long-term growth rate for the business, ROIC and the cost of capital.

Lets apply this to one of the businesses I purchased in December 2010 (link to my write-up on GuruFocus) — MasterCard (MA). I expect MasterCard to grow at 15% to 20% for the next five years and do it at a very high ROIC of 40% to 50%. However, this cannot last forever. Growth rates slow down as markets get saturated and ROIC goes down as opportunities to invest capital go down. It seems unlikely that new competition can come in and start competing with MasterCard in the foreseeable future for a long time (for reasons I will not go into here, but you can look at my MasterCard write-up). Thus, once the fast growth period ends, I expect MasterCard to be able to continue growing at least 1% to 2% above inflation of 2% (due to pricing power in absence of competition) and continue to do it at ROIC of 15% to 20%. I use 10% as the WACC for MasterCard. Plug this into the formula, you get a multiple of 11x to 13x of 2016E NOPAT. Since NOPAT can grow at 15% to 20% in the 5 years from 2012-2016, 2016E NOPAT will be at 2x to 2.5x of 2011 NOPAT. Hence, the fair value of MasterCard's Enterprise Value is between 22x to 30x of 2011 NOPAT + sum of free cash flows generated for the years 2011 through 2016 discounted to present (which we'll ignore for simplicity sake). When I purchased MasterCard in Dec 2010, it was trading at 14.5x of 2010 NOPAT. It's up 60% from my purchase price and today it is trading at 19x 2011 NOPAT. I continue to hold the entire position but it is getting closer to the point where everything good that can happen in the future is starting to get discounted into the price today.

Let me give you another example. For the period from 1968 to 2007, net income at the pharmacy chain, Walgreens, grew at 14% annually and it was among the fastest growing companies in the United States. During this period, the average annual shareholder return (including dividends) was 16%. Now, contrast this with performance at the chewing gum maker Wm. Wrigley Jr. Company during the same period. Wrigley's net income during the same period grew much slower at about 10% a year, but the average annual shareholder return of 17% a year was higher than at Walgreens (WAG). The reason Wrigley could create more value than Walgreens despite 40% slower growth was that it earned a 28% ROIC, while the ROIC for Walgreens was 14% (which is quite good for a retailer).

Next time you hear the words "This company is trading at only 10x P/E, it must be cheap. Or this company that is at 18x P/E must be expensive," I urge you to think about this article. In all likelihood the conclusion may be the correct one, but think about the business' ROIC and what about its structure causes it to have a high (or a low) ROIC before drawing that conclusion.

About the author:

Rishi Gosalia
Rishi Gosalia is a private value investor based in Cedar Park, TX. Rishi currently works in a management position in the software industry. Rishi graduated from the University of Texas at Austin in 2003 as a Distinguished Scholar with an undergraduate degree in both Computer Science and Pure Mathematics.

Rating: 4.4/5 (28 votes)

Comments

Fake61Stupid
Fake61Stupid - 3 years ago
Shouldn't all of your equations state (G - WACC) as opposed to (WACC - G)? The way you calculated it, the implication is that you should capitalize FCF by a negative number.

Using your mastercard example, EV = FCF/ (WACC - G) ---> EV = FCF/(10%-15) ---> EV = FCF/-5%

So your EV would be negative for all companies that grow faster than their cost of capital, in reality shouldn't it be the opposite?

(Excuse the handle, I hate websites that don't allow you to post as a guest.)
rgosalia
Rgosalia - 3 years ago
The perpetual factor discounted by (WACC - G) is correct. In the case of MasterCard, I am plugging in G to be 1% to 2% above inflation of 2% i.e G to be 3% to 4%. The 15% to 20% is only for 2011 to 2016, so it does not make sense to plug that into the perpetual factor.

There are very very few companies that can grow for years at rates above cost of capital - either competition comes in and slows down growth or markets in which the company operates gets saturated driving down growth rates.

Hope this clarifies

- Rishi
shadowstock
Shadowstock premium member - 3 years ago


Outstanding article!
Sivaram
Sivaram - 3 years ago
Good article Rishi! It captures the interplay between key elements of shareholder wealth creation.
rgosalia
Rgosalia - 3 years ago
Thank you Shadowstock and Sivaram. The credit goes to the authors of the book, I am only the messenger here.
bajjiblow
Bajjiblow - 3 years ago
Very good article .Thanks
bajjiblow
Bajjiblow - 3 years ago
Rishi,

Can you explain how you ended up with 10% value for WACC ? Is that a guess or a calculated value ?
rgosalia
Rgosalia - 3 years ago
MasterCard has no debt, so WACC is simply the cost of equity. Unlike in the finance literature that uses beta and CAPM to calculate the cost of equity, I prefer to use the simple method of adding a risk premium to 10 year treasury yield. Currently, thanks to the FED, the yield curve has flattened, so using the current treasury yield, you can make any stock look good. Instead, I use the historical average of 4% for the 10 year Treasury yield and then add a risk premium of 6% to get to a cost of equity of 10%.

- Rishi
superguru
Superguru - 3 years ago
great article Rishi
Adib Motiwala
Adib Motiwala - 3 years ago
Good article Rishi!
ihnfi
Ihnfi - 3 years ago
For MA, shouldn't you discount the 2016 NOPAT at the WACC to calculate the 2011 EV/NOPAT multiple?
rgosalia
Rgosalia - 3 years ago
ihnfi,

If a company is generating $1 of NOPAT today and is trading at 15x and you expect NOPAT to be at $2.5 and trade at a multiple of 12x 5 years from now, then when you get to 2016 your shares that you bought today at $15 will be worth $30 at the end of year 5 - a 2x return or 15% IRR + return from dividends or effect of buybacks for years 2012-2016. This meets my hurdle rate of 10% (WACC or cost of equity I have been using). That's the logic I used above.

You can discount 2016E if you want and get the PV of the $30 stock - you'll get $18.6. If we wanted to be precise, then you add in the PV of the cash flows for the year for 2012-2016. But that's the same thing as above expressed in a different way mathematically.

Thoughts?

- Rishi

ihnfi
Ihnfi - 3 years ago
I should have started my last comment with, "great post".

I recognize that MA was presented as an example and the fact that you ignored the cash flow generated between '12-16 showed that you were presenting it to illustrate your point.

I think we wind up in the same place (haven't done the calculations), but to calculate precisely, you should discount 2016 back to today and add in the cash flow generated in the interim.

Again, appreciate the great post.

Thanks
accumulate
Accumulate - 3 years ago


This is a great post. It highlights the fact that there is an awefull lot that a do not understand. Can anyone point me to a book, or articles on the subject of wacc and roic for beginners
benethridge
Benethridge - 3 years ago
The problem with ROIC (or ROE for that matter) is that is not "your number". It's the "company's number". The ROIC above only becomes "your number", if you purchase the stock at the book value (P/B = 1.0). That is because ROIC (and ROE) are based on the book value, i.e. the "equity", right? In the above, it sounds like you are thinking of that ROIC number as "your number", which it isn't coz you didn't buy MC at the book value, right?

P/E is "your number". If you buy the stock at such-and-such price, you immediately "get" such-and-such earnings and such-and-such earnings yield (E/P) for the $ you just spent. What management DOES with those earnings is a whole other question....

To paraphrase Buffett, "The price you pay determines the yield you get". That would include P/E, ROIC, ROE and all other such "return" numbers.

Bottom line is that ALL the key numbers have to be scrutinized and CNBC could just as easily start abusing ROIC, if, instead of P/E, that becomes the number most uneducated investors fixate on.

It would be nice if Gurufocus, in addition to the P/E, would show me the "ROIC yield", taking price paid and P/B into account. That would be a more meaningful number than ROIC at purchase decision time, IMHO.

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