Take a look at the table and graph given below. Company A earns $10 every year and has a payout ratio of 100%. Company B earns $10 and has a payout of 50%. It reinvests the remaining 50% to engender its growth. Company A doesn’t grow at all and B grows at a constant rate of 5% forever. Here are some questions that I have for you (1) how much would you pay for A and B today? (2) does B’s growth add any value to its owners?
If you concluded that B is more valuable than A then you flunked the growth test. In order to value a constant earnings stream, both no-growth and growth, you can use the gordon’s growth model. I wrote about it in detail here. The value of A comes to $83.33 [ $10 / 0.12 ] compared to its invested capital of $100. Why is the valuation of A less than its invested capital? This is because A earns 10% on its capital which is less than its cost-of-capital of 12%. The key point to remember is that an asset is worth less than its book if it earns less than its cost-of-capital.
The value of B comes to $71.43 [ $5 / (0.12 – 0.05) ] compared to its invested capital of $100. As B earns less than its cost-of-capital it should be worth less than its book value. But what surprised me was that B which is growing at 5% is worth less than A which is not growing at all. How’s that possible? In order to answer this question we need to do a little bit of algebra. Don’t worry the math is not hard. And we’ll get a deeper insight from this effort.
Let C = Invested capital ROIC = Return on invested capital R = Cost of capital G = Growth rate I = Reinvestment back into the business to engender growth CF = Distributable cash flow to shareholders
The key insight to derive from the above equation is the ratio [ ( ROIC – G) / ( R – G) ]. This ratio can result in three different conditions (1) when ROIC < R; under this condition the ratio goes below 1 and any investment in growth will destroy value. This is what happened to B. And this is the reason why it was valued less than A which didn’t invest anything in growth. (2) when ROIC = R; under this condition the ratio equals 1 and investment in growth neither adds nor destroys value. (3) when ROIC > R; under this condition the ratio goes above 1 and this is the only condition where growth adds value to its owners. This concept is beautifully summarized by Greenwald in his fantastic book.
ROIC < R: Growth may be worse than neutral; it may actually destroy value. This occurs whenever the return on capital is less than the cost of capital. Returning to our growth value factor F, if ROIC = .10, and R = .12, then F = (.10 – G)/(.12 – G). In this situation, F will (a) always be less than one no matter what the rate of growth, (b) get smaller as the rate of growth increases, and (c) fall to zero when G reaches 10 percent annual growth. As long as it costs us more for each dollar of new investment than that dollar will produce in increased earnings, growth destroys value. Higher growth rates require more investment and thus destroy value even faster.
ROIC = R: Growth requires additional investment, and although this investment produces a return on capital, the financiers who supply it demand payment for the use of their funds, which is the cost of capital. When ROIC = R, the entire proceeds from the investment go to compensate the providers of the new funds; there is nothing left to pay to the existing owners of the firm. Therefore, no matter how much the new investment generates in increased revenue and earnings, the value of the firm to its existing owners does not change.
ROIC > R: Growth, it is now clear, only adds value when the return on capital is greater than the cost of capital (ROIC > R). Only in markets where a company enjoys a sustainable competitive advantage, protected within its franchise by barriers to entry, will returns on capital be greater than the cost of capital. So the basic principle of growth valuation comes down to this: Only growth within the franchise reliably creates value.
Don’t blindly buy a stock because it’s growing its sales and earnings. The most important question to ask is: What Is Growth Worth? Growth is worth more for businesses that earns more than its cost-of-capital. And this only happens to those with durable competitive advantage; moats.