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AllP/Esarenotcreatedequal
Highpricetoearningsratiosareaboutmorethangrowth.Understandingtheingredientsthatgointoa
strongmultiplecanhelpexecutivesmakethemostofthisstrategictool.
March2004 |by NidhiChadda,RobertS.McNish,andWernerRehm

Whenitcomestopricetoearningsratios,mostexecutivesunderstandthatahigh
multipleenhancesacompanysstrategicfreedom.Amongotherbenefits,strongmultiples
canprovidemoremuscletopursueacquisitionsorcutthecostofraisingequitycapital.
Unfortunately,intheireffortstoincreasetheirP/E,manyexecutivesreflexivelytryto
crankupgrowth.Toomanyfailtoappreciatetheimportantrolethatreturnsoncapital
playinchannelinggrowthintoahighorlowmultiple.
Simplyput,growthratesandmultiplesdontmoveinlockstep.Forinstance,theretailer
WilliamsSonomahasaP/Emultipleofabout21,basedonearningsgrowthover
1

15percentinthepastthreetofiveyearsandlowreturnsoncapital. Bycontrast,Coca
2

ColahasaslightlystrongerP/Eat24,despiteitslowergrowthrate. Cokessecret?
Returnsoncapitalover45percentrelativetoa9percentweightedaveragecostofcapital.
Itscommonsense:growthrequiresinvestment,andiftheinvestmentdoesntyieldan
adequatereturnoverthecostofcapital,itwontcreateshareholdervalue.Thatmeansno
boosttosharepriceandnoincreaseintheP/Emultiple.Executiveswhodonotpay
attentiontobothgrowthandreturnsoncapitalruntheriskofachievingtheirgrowth
objectivesbutleavingbehindthebenefitsofahigherP/Eand,moreimportant,not
creatingvalueforshareholders.Theymayalsodiscoverthattheyhaveconfusedtheir
portfolioandinvestmentstrategiesbytreatingsomehighP/Ebusinessesasattractive
growthplatformswhentheyareactuallyhighreturningmaturebusinesseswithfew
3

growthprospects. Betterunderstandingofthewaygrowthandreturnsoncapital
combinetoshapeeachbusinesssmultiplecanproducebothbettergrowthandbetter
investmentdecisions.

Doingthemathonmultiples
4

TherelationshipbetweenP/Emultiplesandgrowthisbasicarithmetic: highmultiples
canresultfromhighreturnsoncapitalinaverageorlowgrowthbusinessesjustaseasily
astheycanresultfromhighgrowth.Butbeware:anyamountofgrowthatlowreturnson
capitalwillnotleadtoahighP/E,becausesuchgrowthdoesnotcreateshareholder
value.

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Toillustrate,considertwocompanieswithidenticalP/Emultiplesof17butwithdifferent
mechanismsforcreatingvalue(Exhibit1).Growth,Inc.,isexpectedtogrowatan
averageannualrateof13percentoverthenexttenyears,whilegeneratinga14percent
returnoninvestedcapital(ROIC),whichismodestlyhigherthanits10percentcostof
capital.Tosustainthatlevelofgrowth,itmustreinvest93centsfromeachdollarof
income(Exhibit2).TherelativelyhighreinvestmentratemeansthatGrowth,Inc.,turns
onlyasmallamountofearningsgrowthintofreecashflowgrowth.Manycompaniesfit
thisgrowthprofile,includingsomethatneedtoreinvestmorethan100percentoftheir
earningstosupporttheirgrowthrate.Incontrast,Returns,Inc.,isexpectedtogrowat
only5percentperyear,aratesimilartolongtermnominalGDPgrowthintheUnited
5

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States. UnlikeGrowth,Inc.,however,Returns,Inc.,investsitscapitalextremely
efficiently.Withareturnoncapitalof35percent,itneedstoreinvestonly14centsofeach
dollartosustainitsgrowth.Asitsearningsgrow,Returns,Inc.,methodicallyturnsthem
intofreecashflow.

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Exhibit1
CompaniescanhaveidenticalP/Emultiplesfordramaticallydifferentreasons.

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Exhibit2
Sustaininghighgrowthrequiresconsiderablymorereinvestmentthansustaininghighreturns.
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BecauseGrowth,Inc.,andReturns,Inc.,takeverydifferentroutestothesame
P/Emultiple,itwouldmakesenseforasavvyexecutivetopursuedifferentgrowthand
investmentstrategiestoincreaseeachbusinesssP/E.Obviously,therarecompanythat
cancombinehighgrowthwithhighreturnsoncapitalshouldenjoyextremelyhigh
multiples.

Thehardpart:Disaggregatingmultiples
Notmanyexecutivesandanalystsworktodiscernhowmuchofacompanyscurrent
valuecanbeattributedtoexpectedgrowthortoreturnsoncapital.Thosewhotryoften
fail.Toseewhy,consideronewidelyusedmodeltobreakdownmultiplesasitmightbe
appliedtoalargeconsumergoodsmanufacturerandafastgrowingretailerwithsimilar
P/Eratios(Exhibit3).

Exhibit3
Traditionalassessmentsofenterprisevaluecanleadtoamisinterpretationofwherevalue
comesfrom.

Enlarge

Thefirststepistoestimatethevalueofcurrentearningsinperpetuity,assumingno
6

growth. Themodelthenattributestheremainingvaluetogrowth.Theinterpretation
fromthissimpletwopartapproachwouldbethatthemarketassumesthattheconsumer

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AllP/Esarenotcreatedequal|McKinsey&Company
goodsmanufacturerwouldhavebettergrowthprospectsthantheretailer.
Butthisreadingmisleadsbecauseitdoesnttakeintoaccountreturnsoncapital.
Discountretailersfightitoutprimarilyonprice,whichtranslatesintolowermarginsand
relativelylowreturnsoncapitalsimilartoGrowth,Inc.Incontrast,consumergoods
companiescompeteinanenvironmentwherebrandequitycangeneratehighermargins
andreturnsoncapital,makingthemmorelikeReturns,Inc.Infact,thesimpletwopart
modeliswrong.Thediscountretailerisactuallyexpectedtogrowfasterandtocreate
morevaluefromgrowththantheconsumergoodscompany,whosehighvaluationwould
beprimarilybasedonhighreturnsoncapital.
Anexecutiverelyingonthefaultyanalysisproducedbysuchasimplemodelmightflirt
withtrouble.TheCEOoftheconsumergoodscompanymightincreaseinvestmentor
discountpricestodrivegrowth,potentiallydestroyingshareholdervalueinthelongrun.
Bydiggingalittledeeperandappreciatingtheroleofreturnsoncapital,theCEOwould
morelikelyfocusonprotectinghighreturnsandmarketshare.

AccountingfortheROICpremium
Howcanweavoidthesemisinterpretationsandstillkeeptheanalysisrelativelysimple?
Inourexperience,thebestwaytounderstandtherespectiverolesofreturnsoncapital
andgrowthinshapingacompanysP/Eistoexpandthesimpletwopartmodeland
drawoutaP/Epremiumforhighreturnsoninvestedcapital.Thisapproacheffectively
disaggregatesvalueintothreeeasilyunderstoodparts:
Currentperformance.Currentperformanceisstillestimatedintheusualmanner,asthe
valueofcurrentaftertaxoperatingearningsinperpetuity,assumingnogrowth.
Intuitively,thisisthevalueofsimplymaintainingtheinvestmentsthecompanyhas
alreadymade.
Returnpremium.Thisisthevalueacompanydeliversbyearningsuperiorreturnsonits
growthcapital.Inordertoassesshowacompanysreturnongrowthcapitalinfluences
itsP/Emultiple,werecommenddiscountingacompanyscashflowsasiftheygrewin
7

perpetuityatsomenormalizedrate,suchasnominalGDPgrowth. Throughrepeated
analyses,wehavefoundthattheresultisagoodproxyforthepremiumacompanyenjoys
inthecapitalmarketsbecauseofitshighreturnsonfuturegrowthcapital.Inour
example,theconsumergoodsmanufacturerwouldenjoyalargereturnpremium,
consistentwithitshighhistoricalreturnsoncapital.
Valuefromgrowth.Thisvaluerepresentshowmuchacompanydeliversbygrowingover
andabovenominalGDPgrowth.Itcanbecalculatedasthatportionofthecompanys
8

currentmarketvaluethatisnotcapturedincurrentperformanceorthereturnpremium.
Whilemoresophisticatedandtimeconsuminganalysesaresometimesappropriate,in
ourexperienceexecutivescanlearnalotabouttheirP/Emultiplewiththissimplethree
partmodel.
Howmightanexecutivechangehisorherinsightsabouttheconsumergoodscompany
andthediscountretailerusingthisthreepartmodel?Theconsumergoodscompany
wouldbeseentoenjoyalargepremiumforitsreturnoncapital.Intheconsumergoods
sector,preservingthatreturnpremiummustbeparamount,butanythingthecompany
candotoincreaseitsorganicgrowthratewhilepreservingitsreturnpremiumwould
translatedirectlyintoshareholdervalueandthepossibilityofaveryhighmultiple.

Incontrast,theCEOofthediscountretailerwouldfaceatinypremiumforreturnon
capital,sincehisorhercompanyderivesmostofitsvaluefromtherapidgrowth
prospects.AnythingthiscompanycoulddotoincreaseitsROIC,possiblyevenreiningin
itsgrowthrate,wouldaddvalue.Byapplyingthemodeltocalibratethetradeoffbetween
growthandreturn,theCEOcouldevendeterminethatatopmanagementpriorityisto
redirectsomeattentionfromgrowthtooperationsimprovement.

HighP/Emultiplescanserveasapowerfulstrategictool.Executiveswhounderstandthe
complexchemistryofgrowth,returns,andP/Emultipleswillbebetterpositionedtomake
strategicandoperatingdecisionsthatincreaseshareholdervalue.
Abouttheauthors

NidhiChaddaandWernerRehmareconsultantsinMcKinseysNewYorkoffice,andRobMcNishisa
principalintheWashington,DC,office.

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