Note: Read Valuation Post 11: Calculating Intrinsic P/E - P/E ratio primer 1 before proceeding to this post.
We have Growth and ROIC in the table below so we can find Reinvestment through these 2 factors.
Also one thing you need to keep in mind: don't take growth more than WACC otherwise the denominator will be negative (WACC - G). And if you think that your company can grow more than WACC than you can't make this table (handicap of this table). Also this is practically not possible - a company mathematically cant grow at a rate more than risk free rate of an economy till perpetuity.
Now let's revisit the formula from which we'll use in below data table to get intrinsic P/E:
FCFF = (NOPAT - Reinvestment) Here in our case we don’t have reinvestment so we'll have to find that out. Growth = ROIC * Reinvestment rate. So Reinvestment rate = Growth / ROIC. Remember here we got Reinvestment rate not reinvestment so we again have to multiply this with NOPAT to get reinvestment.
So below is the Image of the final table, after applying the above formula in all cells - the summary is as follows.
1. No matter at what growth the company is growing if it’s ROIC < WACC then P/E won’t be changing due to the growth factor. (Look at second column marked in yellow)
2. Same applies vice versa if your company is not growing but ROIC of the company is increasing then also P/E won’t change. (See last row marked in Yellow)
3. When your company is making economic loss (ROIC < WACC i.e. column 1 in below table) then the market will devalue the company for extra growth.
a) As you can see in the below table, a 0% growth market will have a intrinsic P/E of 10.5 ‘s but for a 8% growth market is giving that same company a P/E of 3.9’s.
If you want the above template then you can download it from here.
So after creating this table below we have created 2 new tables below
Reinvestment rate Table
FCFF Table
Formula in the reinvestment rate table is Growth / ROIC and the formula for FCFF table is 1- Reinvestment rate.
So a Common Pattern emerges after looking at the tables:
Higher the ROIC -> leads to Lower Reinvestment for a particular level of growth -> which leads to increase in FCFF -> which leads to a higher P/E.