With basics in mind from Valuation Post 6 : Drivers of Business valuation Basic Framework Part 1 let’s shift our attention to the key drivers of business valuation.
Let's imagine a business in which there is no leverage and no non-operating income/non-operating asset. Hence, ROE=ROCE=ROIC.
Note: For detailed thread on ROEVs ROCE Vs ROIC Vs ROIIC click here
Now, Let us combine the above framework & help you with derivation of valuation framework.
Let's assume the reinvestment rate of 0% that will lead to the entire NOPAT being FCFF as nothing is being subtracted in form of re-investments.
Starting with a capital of Rs. 100 at point 0, we will have earned 10rs in the form of NOPAT (Capital * ROIC) as Capital would have earned a ROIC of 10%.
Now as reinvestment rate was 0%
FCFF = NOPAT - Re-investments (Reinvestment rate * NOPAT)
= 10 - (0%*100) = 10 - 0
= 10
As the company had zero ere-investment the ending capital into business will be the same as beginning i.e. rs.100.
First Year Ending Capital (beginning capital for second year)
= beginning capital at 0 + Re-investment
= 100 + 0
= 100 Rs.
Same calculations now goes on for 2nd Year
NOPAT of Year 2 = Beginning capital 2nd year * ROIC = 100 * 10% = 10
Re-investment of Year 2 = NOPAT of Year 2 * Reinvestment rate = 10 * 0% = 0
FCFF = NOPAT of Year 2 - Reinvestment of Year 2 = 10 - 0 = 10
Similarly in the attached excel we have forecasted the FCFF till end of 5th Year and calculated terminal value at the end of 5th period using perpetual growth rate.
Note: Read our blogs on terminal value series to understand more about perpetual growth rate method
TV at the end of Year 5 = FCFF of Year 6 / WACC - g
= 10 / 0.15 - 0.0
= 10 /0.15
= 66.67
Here you should see we have kept few critical assumption (This is just help you understand the structure of valuation in Drivers of business valuation part 3 we will break such assumptions to analyze real impacts)
1. The cost of capital or expected return of investors has been assumed at 15% and constant (Yes we know negative interest rate, lower cost of capital, institutional investor affecting the cost of capital etc as variables here - we have discussed them in detail in this post)
2. We have assumed the competitive intensity of business & industry and competitive advantage of the company shall allow the company to generate a ROIC of 10% forever.
3. Growth is assumed at 0% which means the firm is in steady state and it will generate the same Cash flows till eternity.
NOTE: For Competitive Advantages called MOATs Visit our MOAT Series here, for Industry Structural Competitiveness Visit our Porter Framework series here, and summary of book Competition Demystified Visit here and Summary of Book understanding Micheal E Porter Visit here.
With above assumptions we present the below calculations :
PV of future cash flows comes out at 67 and dividing it by expected earnings of the company i.e. NOPAT of Year 1 Rs 10 we get Fair P/E of the company at 6.7 and Fair P/B of the company as 0.67.
Now, please don't rush to buy this company because it is quoting at below P/B multiple of 1 and a single digit P/E.
A lot of people call such businesses cheap as it's available at less than the book value. This thought process is not always true as you can see in above case the company is destroying value by generating a ROIC (10%) lower than it's cost of capital/ WACC (15%). A consistently value destroying business can be available at a P/B of less than 1.
Please don't confuse this with cyclical businesses like Power, Steel etc. Even those companies can sometime for a very long period of time 2-4 years can be available at such low valuations if going through a bad period of losses or industry oversupply or commodity price correction etc. When such businesses turnaround after bottom of the cycle their ROEs rise drastically leading to a sudden 2-5X jump in their market capitalizations. The essence is the ROIC/ROEs are cyclical hence valuations (like P/B, EV/EBITDA etc) are also cyclical in those business.
It also leads us to a powerful conclusion that if a company can’t grow its cash flows the fair P/E of the company which is also called at steady state P/E comes at 1 / Cost of capital = 1 /0.15 = 6.67 (same as our above calculations derived based on FCFF).
Note: Please read Drivers of business valuation part 3 for more advanced learnings
Also, Please read our summary of Michaeal Mauboussin’s (click here to know Michael's solid background in the world of investing) excellent research paper on Steady State and growth P/E Here and Aswath Damodaran’s (click here to know the background of Aswath Damodaran - titled by some as the finest valuation professor today) lecture summary of the same here.
#Valuations #Steady_State_PE #PB_less_than_1 #ROIC_PE_PB_framework