We all have heard of Complan. The age old health drink for kids touted to boost their growth whose advertisements would end with kids proclaiming, “Now I’m a Complan boy/girl!!!”. But what has Complan got to do with companies and valuation? Well this piece is going to show you how much Complan your favourite companies can drink and more importantly digest. In other words this piece is going to show you how much you can expect your companies to grow without compromising on the returns they generate.
First things first, growth expectations are always estimates. Now, there are three ways to estimates growth. You can do it by looking at past performance and extrapolating it into the future, get managers or analysts to estimate for you, or do it yourself. But, past history is not indicative of future performance, managers and analysts are always biased one way or another, and therefore, the veracity of the age old adage ‘Self help is the best help’, is once again verified to be true. So trust yourself above all else and make your best estimate of growth and as you will see going forward from here, estimating growth is not the hardest thing to do.
Let us first understand what drives growth for a company. A company’s growth is mainly dependent on two drivers, namely, how much the company reinvests into the expansion and adding to its asset base and how well it manages its existing assets. The ultimate aim when when using these two drivers is to find the amount of reinvestment as a percentage of earnings, known as the reinvestment rate, and the reinvestment rate is based on how much is reinvested, and how well the amount is reinvested. The company invariably grows at a rate equal to the reinvestment rate. Let us now look at each driver of growth individually.
- Expansion And Augmentation Of Asset Base: This shows how much of a company’s annual earnings are held back for the purpose of employing the retained funds in the direction of expanding the business and adding to the asset base of the business. We must further understand that there are two starting points to find the reinvestment rate when using this driver, namely net income and operating income.
- Net Income: Here our starting point for finding the reinvestment rate is the final net income of the company. Now, we must understand the core formulae underlying this approach:
Retention Ratio: This ratio shows how much of the earnings a company holds back instead of paying the entire amount of earnings as dividends. Retention Ratio = 100 - Dividend Payout. So for example if a company pays a dividend of 20% the Retention Ratio = 100 - 20 = 80%. This shows that the company reinvests 80% of its equity earnings, or more specifically its net income to expand and augment its asset base instead of paying it out in dividend.
Return On Equity: This ratio shows the amount of return generated by the company on the amount it reinvests. Return On Equity = (Net income/Total Book Value Of Equity) x 100. So for example, if the same company as above has a net income of 500 crore and a total book value of 5000 crore the Return On Equity = (500/5000) x 100 = 10%. That means by reinvesting 80% of its equity earnings or net income the company earns a return on equity of 10% on the amount reinvested
Effective Reinvestment Rate Or Growth Rate: The effective growth rate when starting with the net income is simply Retention Ratio x Return On Equity. So in this case the effective growth rate becomes Growth Rate = 80% x 10% = 8%. This means that the company can grow at 8% per annum by reinvesting 80% of its equity earnings or net income in a venture which earns them a return of 10% per annum.
- Operating Income: Here, our starting point for calculating the growth rate is the after tax operating income that the company earns. Now, lets understand the core formulae underlying this approach:
Retention Ratio: This ratio shows how much of the after tax operating income a company can reinvest, unlike the retention ratio under the net income approach, which shows the amount of ultimate net income which can be reinvested. When starting with after tax operating income, Retention Ratio = [(Net Capital Expenditure + Changes in working capital)/After tax Operating income] x 100. So for example if a company has net capex of 200 crore, an increase in working capital of 275 crore and an after tax operating income of 500 crore the retention ratio would be as follows
[(200 + 275)/500] x 100
= 475/500 x 100
This shows that 95% of the after tax operating income goes back into capex and working capital.
Return On Capital: This shows the amount of return a company can generate by reinvesting its operating income into capex and working capital. Return On Capital = [After tax operating income/(Book value of equity + book value of debt - cash)] x 100
So for example, if the company has a book value of debt of 3000 crore, book value of equity of 3500 crore and a cash balance of 500 crore, in addition to the same after tax operating income of 500 crore as used earlier, we get the following return on capital:
Return On Capital = [500/(3000 + 3500 - 500)] x 100
= [500/6000] x 100
This means that the company can generate a return of 8.33% on reinvestments into capex and working capital at the current level of after tax operating income.
Effective Growth Rate: The effective growth rate is once again simply the operating income retention ratio x return on capital or:
95% x 8.33%
This means that the company can grow at a rate of 7.92% by reinvesting 95% of its after tax operating income in capex and working capital while generating a return of 8.33% on the reinvested capital.
That covers estimation of growth based on expansion and augmentation of asset base. This driver usually drives growth in young, high growth companies because the opportunities for and benefits derived from expansion and augmentation are plenty. Now lets look at growth achieved through efficient management of existing assets.
- Growth Through Efficient Management Of Existing Assets: Here, the company does not reinvest in expansion and new assets, it rather manages its existing assets as efficiently as possible, which automatically boosts its return on capital. Efficiency Growth = (Expected ROC next year - Current ROC)/Current ROC. So for example, if a company has a current ROC of 8% and an expected ROC of 10% next year, the efficiency growth rate = (10% - 8%)/8% = 25%
The only drawbacks with this form of growth are that, it can only be sustained for a few years, and the growth is capped, because companies can’t push their efficiency beyond a certain point.
This is why we see this driver, drive growth in large mature companies because they either don’t have avenues for expansion and augmentation of asset base, or because the costs of further expansion and augmentation outweigh the benefits of such expansion.
Whew!!! That was a lot of typing! As I close this piece our I want to remind you that growth without generation of excess returns for stakeholders is of no use, because that would be like your company drinking a lot of Complan, but not digesting it. Also try and determine whether you are valuing a growing or a mature company to better help you decide which driver to use to estimate growth. We will of course, discuss more about growing and mature companies during the intermediate course of my valuation series.
See you next week for Valuation 104, the last part of the basic course, where we will enter the world of relative valuation