I recently read the great book from McKinsey & Co. “Value: the four Cornerstones of Corporate Finance”, and a paper from Michael Mauboussin “What does a Price-Earnings multiple mean?”.
The main lesson is obvious, but very important. This is why repetition it is not harmful (actually a lot like of going to church every week).
There are three fundamental concepts that you can take away from the exhibit. First, a company earning its cost of capital will trade at the commodity price-earnings multiple, 12.5 times in this case, irrespective of growth. You can imagine these companies as being on an economic treadmill: You can speed up or slow down the treadmill of growth and it makes no difference, the companies are not going anywhere. Value neutral companies must first figure out how to increase ROIIC before they worry about growth.
As one can see in the below figure, there are two valuation drivers: ROIC and earnings growth. The most important point: The key valuation driver is the variable at which the company is worst.
P/Es given ROIC and earnings growth (assuming an 8% WACC).
Value neutral companies must first figure out how to increase ROIIC before they worry about growth.
Second, if a company is generating returns in excess of the cost of capital, growth is good. Indeed, all things being equal, faster growth translates directly into a higher price-earnings multiple. For instance, the warranted price-earnings multiple for a company with a 24 percent ROIIC and 4 percent growth is 16.1 times, whereas a company with the same ROIIC but a more rapid growth rate of 10 percent is worth 25.7 times. The value of high ROIIC companies is extremely sensitive to changes in perceived rates of growth.
Therefore:
A high ROIC company with sluggish growth should focus on growth. A low ROIC growth company should focus on capital efficiency.
Important simplification: we keep ROIC constant for different company sizes (e.g. Amazon improves ROIC by growing).
TC
Leave a Reply