iv. operating income growth when return on capital is...
TRANSCRIPT
![Page 1: IV. Operating Income Growth when Return on Capital is Changingpeople.stern.nyu.edu/adamodar/podcasts/valUGspr17/session10.pdf · nKeep track of absolute revenues to make sure that](https://reader034.vdocuments.net/reader034/viewer/2022050407/5f84a8c5b40bb479bd3240b3/html5/thumbnails/1.jpg)
184
IV.OperatingIncomeGrowthwhenReturnonCapitalisChanging
¨ Whenthereturnoncapitalischanging,therewillbeasecondcomponenttogrowth,positiveifthereturnoncapitalisincreasingandnegativeifthereturnoncapitalisdecreasing.
¨ IfROCt isthereturnoncapitalinperiodtandROCt+1 isthereturnoncapitalinperiodt+1,theexpectedgrowthrateinoperatingincomewillbe:
ExpectedGrowthRate=ROCt+1 *Reinvestmentrate+(ROCt+1 – ROCt)/ROCt
¨ Ifthechangeisovermultipleperiods,thesecondcomponentshouldbespreadoutovereachperiod.
Aswath Damodaran
184
![Page 2: IV. Operating Income Growth when Return on Capital is Changingpeople.stern.nyu.edu/adamodar/podcasts/valUGspr17/session10.pdf · nKeep track of absolute revenues to make sure that](https://reader034.vdocuments.net/reader034/viewer/2022050407/5f84a8c5b40bb479bd3240b3/html5/thumbnails/2.jpg)
185
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
Aswath Damodaran
185
![Page 3: IV. Operating Income Growth when Return on Capital is Changingpeople.stern.nyu.edu/adamodar/podcasts/valUGspr17/session10.pdf · nKeep track of absolute revenues to make sure that](https://reader034.vdocuments.net/reader034/viewer/2022050407/5f84a8c5b40bb479bd3240b3/html5/thumbnails/3.jpg)
186
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.
Aswath Damodaran
186
![Page 4: IV. Operating Income Growth when Return on Capital is Changingpeople.stern.nyu.edu/adamodar/podcasts/valUGspr17/session10.pdf · nKeep track of absolute revenues to make sure that](https://reader034.vdocuments.net/reader034/viewer/2022050407/5f84a8c5b40bb479bd3240b3/html5/thumbnails/4.jpg)
TopDownGrowth
GrowthIV187
Aswath Damodaran
![Page 5: IV. Operating Income Growth when Return on Capital is Changingpeople.stern.nyu.edu/adamodar/podcasts/valUGspr17/session10.pdf · nKeep track of absolute revenues to make sure that](https://reader034.vdocuments.net/reader034/viewer/2022050407/5f84a8c5b40bb479bd3240b3/html5/thumbnails/5.jpg)
188
EstimatingGrowthwhenOperatingIncomeisNegativeorMarginsarechanging
¨ Allofthefundamentalgrowthequationsassumethatthefirmhasareturnonequityorreturnoncapitalitcansustaininthelongterm.
¨ Whenoperatingincomeisnegativeormarginsareexpectedtochangeovertime,weuseathreestepprocesstoestimategrowth:¤ Estimategrowthratesinrevenuesovertime
n Determinethetotalmarket(givenyourbusinessmodel)andestimatethemarketsharethatyouthinkyourcompanywillearn.
n Decreasethegrowthrateasthefirmbecomeslargern Keeptrackofabsoluterevenuestomakesurethatthegrowthisfeasible
¤ Estimateexpectedoperatingmarginseachyearn Setatargetmarginthatthefirmwillmovetowardsn Adjustthecurrentmargintowardsthetargetmargin
¤ Estimatethecapitalthatneedstobeinvestedtogeneraterevenuegrowthandexpectedmarginsn Estimateasalestocapitalratiothatyouwillusetogeneratereinvestmentneeds
eachyear.
Aswath Damodaran
188
![Page 6: IV. Operating Income Growth when Return on Capital is Changingpeople.stern.nyu.edu/adamodar/podcasts/valUGspr17/session10.pdf · nKeep track of absolute revenues to make sure that](https://reader034.vdocuments.net/reader034/viewer/2022050407/5f84a8c5b40bb479bd3240b3/html5/thumbnails/6.jpg)
189
TeslainJuly2015:GrowthandProfitability
Aswath Damodaran
189
![Page 7: IV. Operating Income Growth when Return on Capital is Changingpeople.stern.nyu.edu/adamodar/podcasts/valUGspr17/session10.pdf · nKeep track of absolute revenues to make sure that](https://reader034.vdocuments.net/reader034/viewer/2022050407/5f84a8c5b40bb479bd3240b3/html5/thumbnails/7.jpg)
190
Tesla:ReinvestmentandProfitability
Aswath Damodaran
190
![Page 8: IV. Operating Income Growth when Return on Capital is Changingpeople.stern.nyu.edu/adamodar/podcasts/valUGspr17/session10.pdf · nKeep track of absolute revenues to make sure that](https://reader034.vdocuments.net/reader034/viewer/2022050407/5f84a8c5b40bb479bd3240b3/html5/thumbnails/8.jpg)
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
Aswath Damodaran191
![Page 9: IV. Operating Income Growth when Return on Capital is Changingpeople.stern.nyu.edu/adamodar/podcasts/valUGspr17/session10.pdf · nKeep track of absolute revenues to make sure that](https://reader034.vdocuments.net/reader034/viewer/2022050407/5f84a8c5b40bb479bd3240b3/html5/thumbnails/9.jpg)
CLOSUREINVALUATION
TheBigEnchilada
Aswath Damodaran 192
![Page 10: IV. Operating Income Growth when Return on Capital is Changingpeople.stern.nyu.edu/adamodar/podcasts/valUGspr17/session10.pdf · nKeep track of absolute revenues to make sure that](https://reader034.vdocuments.net/reader034/viewer/2022050407/5f84a8c5b40bb479bd3240b3/html5/thumbnails/10.jpg)
193
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∑
Aswath Damodaran
193
![Page 11: IV. Operating Income Growth when Return on Capital is Changingpeople.stern.nyu.edu/adamodar/podcasts/valUGspr17/session10.pdf · nKeep track of absolute revenues to make sure that](https://reader034.vdocuments.net/reader034/viewer/2022050407/5f84a8c5b40bb479bd3240b3/html5/thumbnails/11.jpg)
194
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.
Aswath Damodaran
194
![Page 12: IV. Operating Income Growth when Return on Capital is Changingpeople.stern.nyu.edu/adamodar/podcasts/valUGspr17/session10.pdf · nKeep track of absolute revenues to make sure that](https://reader034.vdocuments.net/reader034/viewer/2022050407/5f84a8c5b40bb479bd3240b3/html5/thumbnails/12.jpg)
195
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.
Aswath Damodaran
195