In this blog we will try to understand mathematically what should be the intrinsic P/E (especially at the time of taking an Exit multiple) of the company given it's ROIC and growth rate.
We have created a Model in Excel which will help you derive the Intrinsic P/E of a company based on a few inputs. This excel template was made when we were reading a research paper of EPOCH partners named “What exactly do you mean by PE”. Read our Summary of EPOCH Partners brilliant work on P/E ratio here.
So we start understanding the model let me tell you it's weakness first. In this table there is an inbuilt assumption that the ROIC (you take in the table) of the company would be the company's ROIC till perpetuity and as we know this assumption can't be true for all the companies. In the very long run (lets say 50 Year & above) a company generally can either maintain its ROIC or Can Maintain an above average growth rate as observed by analyzing the leaders and index constituents across the world over the past 50-70 years.
To prove the above points, let's check the sustainability of High ROE/ROIC of Indian companies. The below table has been taken from a research paper by Motial Oswal (Please read our detailed summary of that research paper here)
So as per this data they have explained that after a company's high growth period it is very difficult for a company to sustain its return over cost of capital (exceptions are always there but this is the major trend observed from the data).
So as you can see only 22 companies managed to sustain it's return more than WACC for 20 years.
Now let us move forward towards how to calculate a company's intrinsic P/E. So let's assume after all our analysis on the company we came to the conclusion:
That after X number of years the ROIC of the company would be Y%.
So at what P/E the stock should trade at the end of 5th year?
Terminal value = free cash flow/ WACC - Growth
FCFF (the numerator) is basically = NOPAT - Reinvestment
= NOPAT - (NOPAT * Reinvestment rate)
= NOPAT - (NOPAT * G/ROIC)
As Growth = ROIC * Reinvestment rate
Terminal Value becomes = NOPAT - (NOPAT * G/ROIC) / WACC - g
Now if we assume NOPAT = 1 rupees (just to neutralize across different scales of companies) so we'll get Terminal value Multiple as 1 - (1* g/ROIC) / WACC - G
This becomes multiple that we can multiply with actual/absolute value of FCFF to derive the terminal value.
There will be a total of three variables affecting the multiple of the company
Sustainable Growth rate of NOPAT
Sustainable Weighted Average Cost of Capital/ WACC / Cost of Capital
In the below table we have created various combinations of ROIC and Growth rates at a particular level of WACC:
In the next post we'll understand how Economic profit (ROIC>COC) and Growth combined will help you to come at a reasonable Intrinsic P/E or Intrinsic exit multiple for your business.
Basically we will talk about what output the above tables throws in front of us.
NOTE 1: If you want to read more about how economic profits i.e. ROIC > COC affects valuation do read our Valuation Post 5 to Valuation Post 10.
Note 2: This has to be applied on stable growing business or reasonably forecastable businesses not on cyclical or commodity business. But still if you take these types of companies then take a long 15-20 years average ROIC which they have been able to sustain.