Sunday, November 20, 2011

Fundamentals of Value Creation

This section is heavily borrowed from the book "Valuation: Measuring and Managing the Value of Companies". In my opinion, this book has one of the clearest explanations on the drivers of value creation for a company. I say this after reading many books to try to understand this topic. At close to 800 pages, this is not an easy read, but if you are into this kind of thing, I promise it is worth the effort. 

Consider the following two hypothetical companies Value and Volume, whose projected revenues and earnings are identical. Both companies earn $100 million in year 1 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 multiple 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. 

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 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%.

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 * (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 (similar to the ratio used in Joel Greenblatt's ratio EV/EBIT but its pre-tax) 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 own today - MasterCard. I expect MasterCard to grow at 15% to 20% for the next 5 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 from December 2010). 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 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. 

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. 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.

1 comment:

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