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I promised my friends that I will do a small presentation on the drivers of the intrinsic value of a
business. To fulfill that promise I am doing this write up. Take a look at the Net Operating Profits
Less Adjusted Taxes (NOPLAT) for Great and Gruesome. Both companies are generating the
same NOPLAT and growing at the same rate of 10 percent. What is the fair multiple to pay for
Great and Gruesome?
Before answering that question let’s see the definition of NOPLAT. It represents the profits
generated from the company’s core operations after subtracting the income taxes related to the
core operations. From the data given in the above table we can’t find out the fair multiple to pay
for Great and Gruesome. Why is that?
To answer that question we need to know a couple of things. First, we need to know how much
capital did the company deploy [ROIC] to generate the NOPLAT. Second, we need to know how
much did the company reinvest back into the business to generate 10 percent growth. Take a
look at the table given below for Great. It’s ROIC is 20 percent and it reinvests 50 percent of
NOPLAT back into the business to grow at 10 percent.
From this information can we find out the fair multiple to pay for Great? To answer that question
we need one more information which is costofcapital. Let’s assume that to be 15 percent. By
using the Gordon growth model we can value the continuing free cash flow stream by using a
closed form equation which is given below. If you are curious to learn how Gordon arrived at this
equation then click here.
V alue = F ree cash flow / (Cost of capital − Growth rate)
What is a free cash flow? The cash that is left over after investing back into the business is
called as free cash flow. In the proof given below, I have represented free cash flow in terms of
ROIC and Growth. Spend a lot of time to make sure that you understand the derivation. Click on
the image to view it clearly.
The equation to calculate the intrinsic value inside the rectangular box is called as The Zen of
Corporate Finance. Intrinsic value is determined by three key variables — ROIC, Cost Of
Capital, Growth Rate. Using the above equation the intrinsic value for Great comes to $1,000.
What is the fair multiple to pay for Great? We know that the intrinsic value of Great is $1,000.
And its NOPLAT is $100. So the fair multiple to pay is 10 [$1,000 / 100]. All else being equal, an
investor paying a fair multiple for Great is expected to earn a return of 15 percent which is same
as the cost of capital or discount rate.Spend a lot of time to deeply understand the meaning of
the last line.
Take a look at the table given below for Gruesome. It’s ROIC is 14 percent and it reinvests 70
percent of NOPLAT back into the business to grow at 10 percent. Let’s assume the cost of
capital to be the same 15 percent. Using the same Zen of Corporate Finance equation we get
the intrinsic value of Gruesome to be $571.
The fair multiple to pay for Gruesome is 5.71 [$571 / 100]. All else being equal, an investor
paying a fair multiple for Gruesome is expected to earn a return of 15 percent which is the same
as the cost of capital or discount rate. Both Great and Gruesome have been generating the
same NOPLAT and growing at the same rate of 10 percent. Then why is the fair value of Great
is almost twice that of Gruesome?
To answer that we need to focus on three key variables — ROIC, Cost Of Capital, Growth Rate.
We know that cost of capital for Great and Gruesome is the same 15 percent. Also their growth
rates is the same 10 percent. From this we can conclude that cost of capital and growth rates
didn’t cause their fair values to differ.
The reason for their difference is ROIC. Great earns a higher ROIC of 20 percent. This allows it
to reinvest only 50 percent of NOPLAT to achieve the growth rate of 10 percent. This increases
the free cash flow generated by Great and this results in higher intrinsic value. Also its ROIC is
greater than the cost of capital of 15 percent.
On the other hand, Gruesome earns a lower ROIC of 14 percent. To achieve the same growth
rate of 10 percent it needs to reinvest 70 percent of NOPLAT. This reduces the free cash flow of
Gruesome and this results in lower intrinsic value. Also, Gruesome ROIC of 14 percent is lesser
than cost of capital of 15 percent.
Here are some important points that we can learn from this exercise (1)
Higher free cash flow
results in greater intrinsic value
(2)
Growth adds value only when ROIC is greater than cost of
capital
(3)
If ROIC > Cost of Capital it makes a lot of sense for the management to reinvest it
back into the business. If this is not the case then it makes a lot of sense for the management to
return the cash back to the shareholders. The table given below clearly validates these points.
Knowledge without application is useless. Only in made up examples growth goes up in straight
line and ROIC stays constant above the cost of capital. In real life, growth and ROIC, ebbs and
flows. In the table given below, I applied the Zen of Corporate Finance to Nestle India. In 2005,
each share of Nestle India was selling for 936 rupees. And the pricetoearnings ratio was 29.
With the benefit of hindsight, I calculated the intrinsic value and fair multiple of Nestle India
stock in 2005. From 2006 to 2014, Nestle India had an average ROIC of 86 percent. And it was
able to able to grow its NOPLAT by almost 18 percent with an reinvestment rate of only 50
percent. In other words, Nestle India was able to grow at a healthy rate and at the same time
was able to generate tons of free cash flow.
With a cost of capital of 12 percent and terminal growth rate of 8 percent and ROIC of 50
percent the intrinsic value of Nestle India share in 2005 should be around 1,260 rupees. And it
had a fair value multiple of 35. Even at the pricetoearnings ratio of 29 the stock is cheap. In
other words you are buying $1 for 74 cents. Hindsight is always 2020. I am not trying to tell you
to buy a quality business at any price. The point of this post is to show what drives the intrinsic
value of a business. By now it should be very clear that a growing business with high ROIC will
have high intrinsic value and fair value multiple.
References
1. Read chapter 3 from Valuation: Measuring and Managing the Value of Companies .
2. Read Importance of ROIC all five parts from Base Hit Investing.
3. Lecture on valuation by Samit Vartak. Also read his interview on Safal Niveshak
.
4. The Mathematics of Investing by Prof. Sanjay Bakshi.
5. It is all about durability
by Rohit Chauhan.