Tag: valuation

How growth, return on capital, and the discount rate affects valuation

How growth, return on capital, and the discount rate affects valuation

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Michael Mauboussin has written countless white papers on this topic. His paper published on 9 Jun 2020 introduced the concept of how stock duration and interest rates caused multiples of high-quality companies to justifiably shoot up.

High-quality companies have the following characteristics: Return on capital is significantly higher than the cost of capital, able to grow, and has a competitive advantage (i.e. moat).

How is value created?

Before we jump into new concepts such as stock duration, it is important to quickly recap on how value is generated.

A company creates value only when its investments generate a return higher than the opportunity cost of capital (COC).

This means that having a large total addressable market (TAM) with huge growth prospects does not make a good investment. Revenue and earnings may show growth but it offers little with aspect to value creation.

If a company generates a return on capital equaling COC, then it does not matter whether they grow. They are both worth the same multiple.

Mauboussin refers to this group of companies as commodity businesses that deserves a commodity P/E multiple.

The commodity P/E multiple

The commodity P/E multiple is the multiple you would pay for $1 of earnings into infinity assuming no value creation (return on capital = cost of capital).

You can find out the multiple by taking the inverse of the cost of equity capital. If the COC is 8%, the commodity P/E multiple is 12.5 (1/0.08 = 12.5).

This multiple is not constant. The multiple a commodity business commands is derived from the cost of equity capital for each period.

The concept of duration

Duration is a concept that bond investors would be familiar with. It measures how a change in interest rates would affect the price of a bond.

The faster an investor is paid back, the lower the duration. The longer it takes to be paid back, the higher the duration.

Let’s take a look at a simplified example.

Assuming a five-year $100,000 bond at 5%. This means the bond will pay you $5,000 at the end of every year.

This would all be fine and the price would remain the same (at $100,000) if interest rates doesn’t change.

If interest rates shot up to 10%, investors would expect to be paid 10% for their investments.

To achieve this interest rate, the $100,000 bond paying $5,000 (5%) annually would have to drop its price to $50,000. Only then it will be able to match the 10% interest rates given by the current market ($5,000 interest on $50,000 bond).

Generally, the longer it takes for an investor to be repaid, the higher the duration will be. And the bigger the magnitude the change in price of the bond when interest rates shift.

How duration affects stock valuation

Similar to bonds, stocks of businesses that reinvest heavily in the short run to generate higher cash flows in the long run have longer durations than companies that lack the opportunities to reinvest.

Duration sheds important insight into understanding the magnitude of an asset price change when interest rates change. Mauboussin highlights, “Long-duration assets are more sensitive to changes in interest rates than are short-duration assets…companies that can invest a lot today at high returns on capital will not only grow faster than the average company, their stocks will have valuations that are more sensitive to changes in the discount rate.

Low interest rates

Low-interest rates are frequently associated with poor economic outlook and slow real earnings growth. This creates a conundrum where low-interest rates raises asset values (i.e. higher value for a stream of cash flows due to lower discount rates), but the prospects are reduced by slower expected cash flow growth.

Data from Robert Shiller suggests that the impact of slow growth will outweigh the former. The P/E multiple for the market has followed an inverted “U”.

Low median P/E multiples are associated with very low and very high interest rates while high median P/E multiples are associated with real interest rates in the middle of the range.

Mauboussin continues to explain, “Research shows that low Treasury yields allow industry leaders to generate excess returns and that the magnitude of those returns increases as yields approach zero. While the median P/E may come under pressure as a result of slower growth prospects, a handful of companies may continue to generate strong growth and return on incremental investment.

How the math works out

Impact of growth rates on valuation

Mauboussin demonstrated how low-interest rates leads to bigger shifts in valuation multiple with the following:

Assuming the base year’s earnings are $100, slowing earnings growth from 10% to 7% reduces next year’s earnings by only 2.7% (from $110 to $107). However, the P/E multiple dropped a steeper 22.9% (from 32.3 to 24.9).

“Investors often calculate the P/E multiple using the current price and next year’s earnings. As a result, they sometimes believe that the market overreacts to what appears to be modest changes in the near-term earnings. But if expectations for the trajectory of growth really do shift down, the large apparent drop in the P/E multiple is completely justified.

Here, next year’s earnings are revised down by 2.6% (from $115 to $112) but the P/E multiple decline is 25.3% lower. When return on incremental invested capital (ROIIC) is well above the COC, the value of the business is very sensitive to changes in the growth rate of NOPAT.

As we can observe in the following graph, growth and the P/E multiple have a convex relationship. In other words, small changes in growth expectations can lead to big changes in the P/E multiple.

This effect is amplified when the company growth rates are high.

“Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous.”

Warren Buffett

The key takeaway here is that growth doesn’t matter for businesses that generate returns close to the COC. However, for companies that are able to generate high returns on capital, it is a huge amplifier of value.

Impact of ROIIC on valuation

ROIIC indicates how much a company is required to invest to attain an assumed growth rate. A high ROIIC means that the company don’t need to invest heavily to grow, leaving a lot of cash on the table for shareholders and vice versa.

Take for example company A and company B, both of them aim to generate a 10% growth in earnings for the next year. From current year earnings of $100 to $110, an additional $10 in earnings.

All else constant, A generates 50% ROIIC while B generates only 25%.

A is only required to invest $20 of the current year’s earnings to achieve an additional $10 ($20 x 50%) in earnings the following year. This leaves $80 of the remaining earnings for its shareholders.

While B is required to invest $40 of the current year’s earnings to achieve an additional $10 (25% x $40) in earnings the following year. Leaving only $60 of the remaining earnings for shareholders.

Thus, a company generating higher returns on capital would rightfully command a higher multiple, assuming growth rates are constant.

Impact of discount rate on valuation

The cost of equity is comprised largely of 2 components – the risk-free rate (i.e. common referred at the yield on the 10-year Treasury note) and the equity risk premium (i.e. how much investors expect in return for assuming risk).

As of 1 Jun 2020, Aswath Damodaran’s estimate of the cost of equity dropped to 6%. The 10-year Treasury note offering historically low yields at 0.7%, while the equity risk premium accounts for 5.3%.

Mauboussin observes “Nearly 90% of the expected return from equities now comes from the risk premium, up from about 75% at the beginning of the year.”

Importantly, long-duration assets are highly sensitive to changes in the discount rate. In today’s environment of low expected returns, the valuation of these companies are substantially higher than before.

Conclusion

Nobody will know where interest rates are headed, but it is important to appreciate the relationship between the discount rate and long-duration assets. In other words, we should be mindful that an increase in interest rates will bring down the valuation of companies that are investing heavily today for higher future cash flows tomorrow.

It is also important to bear in mind that for most companies, return on capital will eventually drift lower with competition, maturation, obsolescence, and disruption. Without a moat protecting its returns, the company will suffer a multiple contraction as observed above.

You may find all of Michael Mauboussin’s work here.


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Why pay up for quality businesses?

Why pay up for quality businesses?

Fundsmith performed an exercise looking at 25 quality compounders, and what an investor could have paid for a compound annual growth rate (CAGR) of 7% between 1973 and 2019. Over this period, the MSCI World Index produced a CAGR of 6.2%.

“An investor could have paid 281 times earnings for L’Oreal, 156 times for Colgate, and 147 times for Brown-Forman and still beat the market.”

Terry Smith, Fundsmith

What this means is that the market continuously underpriced these great businesses over time. Giving investors the opportunity to achieve market-beating returns by sticking to these compounders.

For Fundsmith, quality companies have the following characteristics: high returns on invested capital, strong margins, good cash conversion, defensive business models and long growth runway.

“Provided you have the patience, these quality stocks do tend to produce the sort of performance over long periods of time that makes their valuation fade into insignificance.”

Terry Smith, Fundsmith

The origin of the above statement comes from Charlie Munger “Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.”

Take some time to let the quote above sink in.

Let’s look at what Munger said with an example. We have company A earning 6% and company B making 18%, both with an intrinsic value (IV) of $100 today.

The market price of company A is half of IV, at $50. While company B is commanding a premium and the market is demanding twice of IV at $200.

Now let’s see what happens when Company A compounds its intrinsic value at 6% while Company B compounds its intrinsic value at 18% over 40 years.

Over a long period, the power of compounding will drive Company B’s IV through the roof!

Let’s be conservative and assume that Company A is trading at double of IV at year 40. While Company B is trading at half of IV at year 40.

Even if Company A’s valuation jump by 4 times (from half of IV at year 1 to double of IV at year 40), it’s returns did not deviate far from its ability to generate 6% return on its business.

For company B, even if you paid an expensive looking price (double of IV), and subsequently valuation gets cut (half of IV), it still generated satisfactory returns of 16% for its investors. Close to its 18% return on business.

Key takeaway

The key takeaway is to understand value. Undervalued companies might not come in the form of low P/E or P/B. If these companies are generating returns on capital below their cost of capital, they would rightfully deserve the low multiples.

For companies that are able to sustainably generate returns above cost of capital, they would rightfully deserve a higher multiple.

Especially in today’s environment, its important to shift our mindset away from solely buying companies that are trading at low multiples. Focus on companies that are able to generate market beating returns instead.

Here is an excellent video of Terry Smith explaining the importance of investing in companies that are able to continuously reinvest their earnings at a high return on capital:


Thank you for taking the time to read my blog.

If you’re enjoying the content so far, I’m sure you’ll find 3 Bullet Sunday helpful. As an extension to the regular posts, I send out weekly newsletters sharing timeless ideas on life and finance.

I do not share these content elsewhere.

Join others and subscribe to our newsletter today to receive a free investment checklist!

Figuring out a company’s intrinsic value with PE ratio

Figuring out a company’s intrinsic value with PE ratio

The price-earnings (P/E) multiple is one of the most popular tools which analysts use to value stocks. A company trading at 10x P/E implies that for every $1 in net income generated investors are willing to pay $10 or a 10% earnings yield.

Despite its popularity, it remains one of the most misused misunderstood metric. A share valued at 30x P/E might not be expensive relative to another stock trading at 15x PE. Likewise, a share trading at lower P/E today, when compared to its 10-year median P/E, does not imply that it is a bargain.

To apply this tool, we must first deconstruct the P/E ratio to better understand what goes in. The P/E ratio is a short-cut to arrive at the Discount Cash Flow valuation. The most sensible way to determine the worth of a business is to estimate the cash flows a business will generate for its owners over time, and then discount these cash flows back to their present value.

Hence, to figure out the intrinsic value we need to ask ourselves these questions:

  1. How much free cash flow (FCF) will the business generate over its lifetime for shareholders?
  2. Can the business grow?
  3. What is the discount rate (i.e. required rate of return/cost of capital)?

In this post, we are going to focus on the relationship between – (1) the amount of cash flow the business generates and (2) its ability to grow this future stream of cash flow.

This brings us to the next question, Why is the cash flow available to shareholders different across companies? Two companies with the same amount of revenue and net income may well generate different levels of cash flow for shareholders.

This is because different companies require different amounts of reinvestment in their business for growth. The more a company needs to reinvest to achieve growth, the less the company retains for shareholders. And this variation is largely driven by the differences in the return on invested capital (ROIC) achieved.

ROIC’s impact on FCF & Growth

Consider two companies, Company A and Company B both generate $1 of earnings per share. Both companies aim to grow their earnings by 10% next year. It would require the companies to reinvest their earnings for expansion.

The key is understanding how much capital is required for each company to achieve a growth of 10% in earnings?

Suppose Company A is able to generate 60% ROIC (similar to a business like Mastercard). This means that every $1 invested in the business, results in a 60% growth in earnings. For it to grow its earnings by 10%, Company A would only need to reinvest 16.7% of this year’s profit. Since a 60% return on 16.7% of current earnings will create a 10% increase in profit. This means that Company A is able to distribute 83.3% of current year’s earnings, or 83.3 cents of the $1 in earnings back to shareholders, through dividends, share buybacks, or by reducing its debt.

On the other hand, Company B is only able to generate 12% ROIC (similar to the S&P 500’s average). To grow its earnings by 10%, it would need to reinvest 83.3% of its earnings. Since a 12% return on 83.3% of current earnings will create 10% more profit. This leaves only 16.7 cents of the $1 in earnings for Company B’s shareholders.

Here we can see that Company A’s ROIC is 5 times greater than Company B’s. To achieve the same growth of 10%, Company B needs to reinvest 5 times its earnings compared to Company A.

Essentially, this shows us that not every dollar of earnings is worth the same amount. Although both companies have the same earnings per share of $1 and generate 10% growth, they require different reinvestment rates. Thus, it boils down to the ROIC that a company is able to generate.

All else constant, a company with a higher ROIC should command a higher P/E multiple and vice versa. A company trading at 30x P/E and another company trading at 12x P/E could both be fair value.

We need to dig deeper into its ROIC and evaluate its sustainability.

Why growth may destroy value

Not all growth is good for shareholders. For growth to generate value for shareholders, its ROIC must be greater than its cost of capital.

The S&P 500 index has returned an average of approximately 10% since inception. Hence, we can consider using 10% as the cost of capital. When deciding whether or not to grow, management should evaluate whether the ROIC from reinvesting earnings could exceed 10%.

If ROIC is 8%, reinvesting for growth would reduce value for investors. Companies should choose to distribute out all its earnings to shareholders as the returns from reinvesting earnings fails to exceed the cost of capital of 10%.

The best way to think about this is to imagine a company borrowing at 10% interest rate and investing for 8% returns. Every dollar borrowed to invest for growth would result in a -2% returns for shareholders. While the cost of equity capital isn’t an interest expense, it is an opportunity cost for investors.

It is important to be aware of this. Even if companies have the same earnings per share and the same growth rate does not mean that they are worth the same P/E multiple. Because ROIC makes a huge difference to whether growth adds value, or destroys value.

How to think about the P/E ratio

In assessing the worth of a company using the P/E ratio, we must first consider whether the company is able to generate ROIC in excess of the cost of capital and growth second. Growth only creates value if the investments generate a return in excess of cost of capital.

For example, here is a quick and dirty way to evaluate Apple’s P/E ratio:

Apple’s Stock Price Chart

It has traded at P/E of below 10x two times over the past decade (points A and B). This is way below Apple’s average P/E ratio. Mr Market was essentially saying that Apple is unable to maintain its ROIC and was unlikely to grow further.

When compared with the broad market’s valuation (S&P 500). Apple was also below the market’s valuation P/E ratio of 17x during point A and 21x during point B. Mr Market was telling us that Apple’s ROIC and growth will be lower compared to the average American company.

Investors should then evaluate if the current P/E underestimates Apple’s ROIC and growth going forward.

In hindsight, Apple continued to generate a high ROIC of approximately 30% and grew its EPS at a CAGR of 11.13%. A rate far above the S&P 500’s ROIC of 12% but lower than Apple’s historical average ROIC of 40%. Apple should rightfully have suffered a P/E contraction. But Mr. Market over discounted Apple with its P/E collapsing below the average S&P 500 companies’ P/E multiple.

Mr. Market eventually corrected Apple’s P/E multiple. Investors who have been right on evaluating its ROIC and growth, and bought Apple when it was trading at P/E multiple of ~10x would generate handsome returns of approximately 600% in 7 years and more than 300% in 4 years if they bought in at points A and B respectively.

Apple’s Stock Price Chart

For more information on understanding P/E ratios, readers may check out the white papers published by Epoch Investment Partners and Michael Mauboussin.

I also wish to share that I’m currently reading the updated version of the book Joys of Compounding by Gautam Baid. This book is highly recommended, and it is incredibly helpful in improving my thoughts about personal finance, investing, and life in general.

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