In the last post (Valuation Post 8: Drivers of Business valuation framework Part 3 growth Impact)we understood what if ONLY growth increases without an improvement in ROIC (increase) or WACC (decrease) it won’t increase the valuation multiples in fact sometimes growth can decrease multiples.
In this post we will understand the Impact of ROIC increase (keeping growth constant at 0%) on Valuation. The ROIC increase will have three scenarios:
1. ROIC increases but is still below or equal to Cost of Capital with 0% growth in company
So as you can see from the above example,
P/B now equals 1 as company's Return is equal to WACC BUT
Company’s PE Ratio was remained the same
2. ROIC crosses the hurdle of Cost of Capital with 0% growth in company
Now, let us look at scenarios where returns are higher than WACC but the company is not growing. P/E of a company doesn't change when there is no growth in a company no matter what return that company would be generating, So below I have taken 2 examples in which i have increased returns till 3 digit but still P/E of the company is not changing.
So as you can see we have assumed the company's return 50% in the 5th example and 700% in the sixth example also but the P/E of the company hasn't changed because there was no growth. Change in terminal value and P/b is there but there is no change in P/E as the company isn't growing.
Hence, a significant conclusion here is ROIC changes/improvements has NO IMPACT on P/E ratio of the company but significant Impact on P/B ratio of the company (especially when ROIC crosses the mark of Cost of Capital).
That's why in Lending business value is based on the relationship between ROIC/ROCE/ROE, Cost of Capital and spread between them measured through P/B ratio.
As in lending business the balance sheet is liquid, assets are at current value and the main Functionality of the bank is to Make more ROIC than Cost of Capital (keeping risk in check).
Also read our notes of Sanjay Bakshi's (read his Bio) excellent session on P/B ratio and Bhav Bhagwan Che for understading valuations especially P/B Ratio.
Read out Final Part on drivers of valuation in valuation Post 10.