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? Click here to read the rest.

## 32 thoughts on “The Zen of Corporate Finance”

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Great Post.

Was wondering if RoIC forms the upper bound for growth? That is growth for the interim period, not the terminal growth rate.

Yash,

Yes for most of the companies ROIC becomes the upper bound. But there are few companies that can grow without any additional invested capital like Facebook, Google, Sees Candies. In those cases even ROIC goes up.

Regards,

Jana

I am always interested to read your blog because it gives more information and thoroughly analyzed. Thanks for sharing your knowledge and looking for many more inputs from you.

Thanks Srini.

Regards,

Jana

Great post! Liked the way you simplified this. The collection of links included towards the end is quite enriching. Thanks for this.

Thanks Rohit.

Regards,

Jana

Hi Jana,

Great post.

I need clarification in Nestle example…

In year 2011,

NOPLAT is 1053 Cr

Reinvestment 1555 cr

then how free cash flow is 1081 cr?

as FCF = NOPLAT – Net Investment

Sachin,

It is a mistake on my part. I fixed it and updated the document. While correcting I found another mistake and calculated the intrinsic value for 2005 as the discounting period was for that year.

Thanks for point it out. I owe you a treat for that.

Regards,

Jana

Thanks Jana. I always waiting for your post because it has lots of wisdom. You analyzed thoroughly and present things very simplified way any novice can understand. Thanks for sharing your knowledge. I am gaining lots of insights from your blogs

Thanks Sachin.

Regards,

Jana

Hi Jana,

Thanks for another great post !! I assume NOPLAT is equal to Net Income in US .

Regards

Balaji

Balaji,

It’s not net income. NOPLAT is applicable to companies all over the world. It’s what the core operating business earns after accounting for taxes.

Regards,

Jana

Can you please explain how NOPLAT is derived from Operating income ? ( Net Operating Profit = ?)

Thanks,

Balaji

Balaji,

In my lecture notes https://goo.gl/6bQ1cD read the section – Using what it owns did the company generate profits?

Regards,

Jana

amazing article jana.

Thanks Ayan.

Regards,

Jana

Hi Jana,

Inspiring article! Thanks for sharing it.

For learning purpose, I have made attempts to redo the zen formula for calculating the intrinsic value for Nestle in 2006.

Growth rate = ROIC × Investment rate.

Roic = 100%

Investment rate = 40%

So growth rate = .4 × 1 = .4 = 40%

When I apply this growth rate to the zen formula , in the denominator segment , that is ( cost of capital – growth rate)

Cost of capital = 12% = .12

Growth rate = 40% = .40

(cost of capital – growth rate) = ( .12 – .40) = (-.28)

That is a negative denominator.

In the numerator section

345 ( 1 – .4/1) = 207cr

I am unable to arrive at the 1259Rs intrinsic value figure.Kindly point out the error in my calculation.

Thanks in advance.

Sreenath,

Thanks. When growth rate > cost of capital the formula wont work. Refer to my other article on when this would happen https://goo.gl/GHBcyX.

To handle it you need to do a discount the individual years and at the very end calculate the terminal value using the Zen Of Corporate Finance equation.

Regards,

Jana

Thanks a lot! Its a valuable tool.

Best regards,

Sreenath

In geometric series Gordon growth model post, 1$ of owners earnings after 7 years of 20% growth ,it reverts to a mean growth of 3%. At a discount rate of 10% the formula used is 2.99/(.1-.03)..to arrive at value of $42.66.

But here in the zen formula, for calculating ‘growth rate’ in the denominator.. Growth rate = ROIC × investment rate.

Should we use this value(Roic ×investmemt rate) or use directly the terminal growth rate ie 3% ?

Please clarify.

Thank you.

Sreenath,

They are the same. In Gordon Growth Model I used owners earnings (read it as free cash flow). In the latest post the free cash flow is broken down into two key components – Growth and ROIC. Refer to my derivation in the latest post one more time.

Regards,

Jana

Excellent post, Jana. Many thanks. Jayan

Jana, Just need to understand a bit more regarding this point- “we need to know howmuch did the company reinvest back into the business to generate 10 percent growth”.

Does this reinvestment means capex undergone by the company each year , because in the nestle case, it is seen that, free cash flow+reinvestment=NOPLAT. However in companies with interest payment obligations, a portion of this reinvestment gets eaten up. So in case of companies with a bit of debt we need to adjust. Waiting for ur valued feedback.

Regards Ayan

Ayan,

Yes for your first question. For companies with debt I get the value of the company without any debt. From that I subtract the net financial obligations (All debt – cash + investments). I wrote about it https://goo.gl/iBT25q.

Regards,

Jana

Jana,

Just need to clarify one thing. In the nestle case in which u have deduced the intrinsic value to be 1259.94 per share. In case of calculation of terminal value, ur terminal value has come 10314 cr.

However if we take the last year’s i.e. 2014’s discounted cash flow of 426 then, 426*( 1+.08)/ ( .12-.08) = 11502 cr. which is the terminal value and which differs from ur value. Please rectify me if I am wrong regarding calculation of terminal value and kindly show me the correct way , i.e. how u came about at the terminal value of 10314 cr. Regards Ayan

Ayan,

Terminal value = ( Final year NOPLAT * (1 – (g / ROIC)) / (cost of capital – g)) / (1.12) ^ 9

Terminal value = ( 1362 * (1 – (0.08 / 0.5)) / (0.12 – 0.08)) / (1.12) ^ 9

Regards,

Jana

Thanks a lot Jana. It’s a wonderful article. Regards Ayan

Jana,

While calculating the intrinsic value of “great ” , we take {$100(1-(0.1/0.2)}/(0.15-0.1). Here we have taken the rate of growth as 10%. However here we can take the liberty of taking a higher growth rate as we are directly deducing the intrinsic value from 2016 – NOPLAT value of “Great” which is $100. Because sitting in 2016, we can safely assume that the industry in which company “Great” belongs, will continue to show robust growth for the 1st 10 years say around 20% growth and terminally the growth will taper to say 3%.So on an average we can assume 10% growth. Accepted that “Great” is only an example for understanding concepts. However for deducing intrinsic values of real life companies from just its latest year NOPLAT value , this growth rate assumption is clearly tricky. It will depend from industry to industry. Still I feel it should hover between 2% to a maximum of 6% and not beyond that for providing adequate margin of safety.

Thanks and regards

Ayan

Ayan,

The math is easy to understand. But in real life calculating Growth and ROIC for long periods of time is really hard. But they drive the intrinsic value. Two things that will helps us are (1) avoid precision and instead use ranges (2) seek margin of safety.

Regards,

Jana

Thanks Jana for your valuable feedback. Regards Ayan

Hello Jana.I have to say I am big fan of yours.You explain the powerful ideas with such simplicity that I find it mesmerizing.I want to ask few questions

1. Can mental models explain most of the things around us in real world?

2. How can I learn accounting so that its not a obstacle in my path to become a value investor like you?

3. Can you please present a roadmap as to where should I begin as I have read many articles of yours but not in a particular order?

Hi Vinayak,

Happy to know that you found my writings useful.

1. https://goo.gl/LyyEJr will answer your question.

2. Take this Coursera course on financial accounting https://goo.gl/fBNtaW. Also read the book http://goo.gl/754J8r.

3. You can start with my lecture notes https://goo.gl/6bQ1cD and slowly build up from there. Once you get a decent hang of the basics pick up an annual report of the companies products that you are most familiar with. This will get you started and you will move from theory to practice.

Regards,

Jana