Valuation is a big part of security analysis. But before choosing a valuation model and begin crunching numbers, security analysts must understand how the company behind an equity security creates value.
A good place to begin is the Merton Miller and Franco Modigliani formula, which breaks the firm's value creation process into two parts, steady-state value and future value.
In this model, the value of the company is equal to the sum of steady-state and future value creation. Meanwhile, the company's value is equal to debt plus equity. Thus, equity value is equal to the sum of steady-state and future value creation minus debt.
This discussion focuses on the first part of equity value, steady-state.
A company is in a steady-state if it fails to create any future value; its investments yield returns that do not exceed the cost of capital. Investment returns are usually measured by the return on invested capital.
The cost of capital is usually measured by the weighted average cost of capital, which can be considered as the opportunity cost of capital invested in a firm's equity and debt.
The difference between ROIC and WACC measures what economists call "economic profit," the excess returns the company earns over the opportunity cost of capital or "normal profit."
Economic profit is used to determine how effectively the company manages and how strong its competitive advantage: the higher the economic profit, the stronger its competitive advantage.
Thus, a company is in a steady-state when ROIC equals WACC; it earns no economic profit and has no competitive advantage. Its earnings grow at the cost of capital.
In "What Does a Price-Earnings Multiple Mean?" Michael J. Mauboussin and Dan Callahan emphasized "this discussion is independent of growth."
"A company can continue to grow earnings as it invests at the cost of capital," they said. "It will just fail to create value and hence should trade at its steady-stay worth. We can readily translate from the steady-state price-earnings multiple, which is the reciprocal of equity."
Formally, steady-state price-earnings equals 1 divided by the cost of equity.
Back in 2014, New York University Professor Aswath Damodaran estimated that the cost of equity is 8% for the U.S. Therefore, the steady-state for the price-earnings multiple for U.S. companies is 12.5.
Steady-state multiples can rise and fall in response to changes in capital cost, but these changes affect all equity multiples alike. The steady-state price-earnings multiple can be used to calculate the terminal value for no-growth companies in discounted cash flow models.
For companies that trade at an earnings multiple of less than 12.5, the market assumes that future growth will lag behind the cost of capital. As for ompanies that trade at an earnings multiple above 12.5, the market assumes that future growth will exceed the cost of capital.
To illustrate this point further, Mauboussin and Callahan modify the steady-state value formula by using the Gordon growth model:
Modified Steady-State Value = Net Operating Profit After Tax (1+growth)/Cost of Capital Growth
According to this formula, companies with positive growth would trade above the steady value price multiple, while those with negative growth would trade below the steady-state multiple, meaning they are value traps.
Generic drugmaker Endo International PLC (ENDP, Financial) is a great example. It has a forward market multiple of 2.86, well below the steady-state multiple. But it isn't a bargain. Economic profit has been hovering near zero in recent years, which means it doesn't create any value (see Exhibit1). Its shares are significantly overvalued according to GuruFocus intrinsic value calculation. (see Exhibit 2).
Exhibit 1
Exhibit 2
In assessing capital allocation, consider incremental returns on capital first and growth second. Growth only creates value if the invested capital generates a return in excess of the cost of capital, an issue to be further addressed in the next part of this series.
Disclosure: No positions.
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