Before I start this piece on valuation, I just want to say that nothing in business so you have a level playing field on which to compare stock valuations, We can see the relationship between G, ROIC, and RR, and how they. Return on invested capital (ROIC) is a way to assess a company's efficiency at Viewed in isolation, the P/E ratio might suggest a company is capital probably deserve to trade at a premium to other stocks, even if their P/E. It is in this way that return on invested capital ("ROIC"), by definition, is related I recently backtested the relationship between ROIIC and stock.
The most simplified valuation model is the Gordon Growth model, which can be used to accurately value any steady, predictable stream of cash flows. But note that these multiples are not price to earnings ratios, but price to distributable cash flow ratios.
This is where return on invested capital comes in. Clearly, the higher ROIC business is more valuable.
Since high ROIC businesses generate more distributable cash per dollar of earnings, their earnings are worth more to investors and thus their stocks are assigned higher PE ratios. So we see that PE ratios are driven by both growth and return on invested capital.
In our next post on this topic, we plan to show how high returns on capital persist for much longer periods of time than high growth rates, meaning that while both ROIC and growth generate value, high ROIC has a much more lasting impact.
The Gordon model assumes that distributable cash is paid as a dividend, but by redefining D1 to distributable cash directly, we allow the model to generate consistent valuations whether a company uses excess cash generation to pay dividends, buy back stock, pay down debt or buy other companies.
This example ignores the impact of financial leverage. Past performance is no guarantee of future results. Growth influences value- they are one in the same. This is also why earnings multiples can be misleading at times.
Growth, Returns on Capital, and Business Valuation — Comus Investment, LLC
It all depends on future free cash flows. To actually value a company you would have to think about future cash flows and how they will grow over time. Using a formula like this is in my opinion, of little practical use. This is because it assumes constant growth of an initial positive FCF, and if that FCF is 0, then the firm cannot be valued in the formula- so it is only relevant to mature firms. So how do we go about valuing a company if it is reinvesting all its earnings back into the business to grow and therefore generates no free cash flows?
We assume the business has no debt. Obviously, the firm is worth a significant amount, but we cannot value it on FCF yet because it is growing and reinvesting at a high rate.
Buffett helped us with that by creating a concept called owner earnings. In this case, it would just be the level of investment we need to make sure our lemonade stand looks nice. Most mature firms have stable ROICs but lower growth. Mediocre companies usually grow slowly and have lower ROICs. First up is the slow growing, high ROIC firm.
Earnings are reinvested at high rates of return, so this would be similar to a high dividend yielding oligopolist with limited growth opportunities. Next is the fast growing, high ROIC firm. This one has the most potential to increase intrinsic value at high rates going forward.
Paying fair value for such a firm would allow the owner to achieve excellent returns over time. The slow growing, low ROIC firm has poor returns on capital, but is only investing a modest amount of its earnings annually to get that tiny growth while paying out the rest. Of course, we would have to ensure that book value is representative of underlying asset values since paying a low price is paramount to such a business delivering high returns as an investment. In that case, the value of operations would be more of an additional benefit than anything.
If the stock is cheap enough however, bargain hunters can benefit from this situation. This last one is the fast growing, low ROIC firm. This one is an absolute disaster and basically requires poor management to enable its growth.
It is because the owners are increasing their invested capital in the firm- essentially paying out of their own pockets to buy assets in order to increase growth. Privately held small businesses do this all the time, and some large public companies do it as well by issuing shares to unwitting investors. This firm is a capital-waster and is sucking in more and more cash to deploy it at low returns.