iv. operating income growth when return on capital is...
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IV.OperatingIncomeGrowthwhenReturnonCapitalisChanging
¨ Whenthereturnoncapitalischanging,therewillbeasecondcomponenttogrowth,positiveifthereturnoncapitalisincreasingandnegativeifthereturnoncapitalisdecreasing.
¨ IfROCt isthereturnoncapitalinperiodtandROCt+1 isthereturnoncapitalinperiodt+1,theexpectedgrowthrateinoperatingincomewillbe:
ExpectedGrowthRate=ROCt+1 *Reinvestmentrate+(ROCt+1 – ROCt)/ROCt
¨ Ifthechangeisovermultipleperiods,thesecondcomponentshouldbespreadoutovereachperiod.
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Motorola’sGrowthRate
¨ Motorola’scurrentreturnoncapitalis12.18%anditsreinvestmentrateis52.99%.
¨ WeexpectMotorola’sreturnoncapitaltoriseto17.22%overthenext5years(whichishalfwaytowardstheindustryaverage)ExpectedGrowthRate=ROCNewInvestments*ReinvestmentRateCurrent+{[1+(ROCIn5years-ROCCurrent)/ROCCurrent]1/5-1}=.1722*.5299+{[1+(.1722-.1218)/.1218]1/5-1}=.1629or16.29%
¨ OnewaytothinkaboutthisistodecomposeMotorola’sexpectedgrowthinto¤Growthfromnewinvestments:.1722*5299=9.12%¤Growthfrommoreefficientlyusingexistinginvestments:16.29%-9.12%=7.17%
NotethatIamassumingthatthenewinvestmentsstartmaking17.22%immediately,whileallowingforexistingassetstoimprovereturnsgradually
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TheValueofGrowth
Expected growth = Growth from new investments + Efficiency growth= Reinv Rate * ROC + (ROCt-ROCt-1)/ROCt-1
Assume that your cost of capital is 10%. As an investor, rank these firms in the order of most value growth to least value growth.
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TopDownGrowth
GrowthIV187
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EstimatingGrowthwhenOperatingIncomeisNegativeorMarginsarechanging
¨ Allofthefundamentalgrowthequationsassumethatthefirmhasareturnonequityorreturnoncapitalitcansustaininthelongterm.
¨ Whenoperatingincomeisnegativeormarginsareexpectedtochangeovertime,weuseathreestepprocesstoestimategrowth:¤ Estimategrowthratesinrevenuesovertime
n Determinethetotalmarket(givenyourbusinessmodel)andestimatethemarketsharethatyouthinkyourcompanywillearn.
n Decreasethegrowthrateasthefirmbecomeslargern Keeptrackofabsoluterevenuestomakesurethatthegrowthisfeasible
¤ Estimateexpectedoperatingmarginseachyearn Setatargetmarginthatthefirmwillmovetowardsn Adjustthecurrentmargintowardsthetargetmargin
¤ Estimatethecapitalthatneedstobeinvestedtogeneraterevenuegrowthandexpectedmarginsn Estimateasalestocapitalratiothatyouwillusetogeneratereinvestmentneeds
eachyear.
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TeslainJuly2015:GrowthandProfitability
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Tesla:ReinvestmentandProfitability
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Expected Growth Rate
Equity Earnings Operating Income
HistoricalFundamentalsAnalysts HistoricalFundamentals
Stable ROE Changing ROE
ROE * Retention RatioROEt+1*Retention Ratio+ (ROEt+1-ROEt)/ROEt
Stable ROC
ROC * Reinvestment Rate
Changing ROC
ROCt+1*Reinvestment Rate+ (ROCt+1-ROCt)/ROCt
Negative Earnings
1. Revenue Growth2. Operating Margins3. Reinvestment NeedsEarnings per share Net Income
Stable ROE Changing ROE
ROE * Equity Reinvestment Ratio
ROEt+1*Eq. Reinv Ratio+ (ROEt+1-ROEt)/ROEt
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CLOSUREINVALUATION
TheBigEnchilada
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GettingClosureinValuation
¨ Apubliclytradedfirmpotentiallyhasaninfinitelife.Thevalueisthereforethepresentvalueofcashflowsforever.
¨ Sincewecannotestimatecashflowsforever,weestimatecashflowsfora“growthperiod” andthenestimateaterminalvalue,tocapturethevalueattheendoftheperiod:
Value = CFt
(1+r)tt=1
t=∞∑
Value = CFt
(1+r)t+
Terminal Value(1+r)N
t=1
t=N∑
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WaysofEstimatingTerminalValue
Terminal Value
Liquidation Value
Multiple Approach Stable Growth Model
Most useful when assets are separable and marketable
Easiest approach but makes the valuation a relative valuation
Technically soundest, but requires that you make judgments about when the firm will grow at a stable rate which it can sustain forever, and the excess returns (if any) that it will earn during the period.
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1.Obeythegrowthcap
¨ Whenafirm’scashflowsgrowata“constant” rateforever,thepresentvalueofthosecashflowscanbewrittenas:Value=ExpectedCashFlowNextPeriod/(r- g)where,
r=Discountrate(CostofEquityorCostofCapital)g=Expectedgrowthrate
¨ Thestablegrowthratecannotexceedthegrowthrateoftheeconomybutitcanbesetlower.• Ifyouassumethattheeconomyiscomposedofhighgrowthandstablegrowthfirms,
thegrowthrateofthelatterwillprobablybelowerthanthegrowthrateoftheeconomy.
• Thestablegrowthratecanbenegative.Theterminalvaluewillbelowerandyouareassumingthatyourfirmwilldisappearovertime.
• Ifyouusenominalcashflows anddiscountrates,thegrowthrateshouldbenominalinthecurrencyinwhichthevaluationisdenominated.
¨ Onesimpleproxyforthenominalgrowthrateoftheeconomyistheriskfree rate.
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