Under these assumptions, we can thus calculate that a theoretically correct valuation, expressed by P/E, for company A is 10x and for company B 14x. In general, the valuation under different ROIC and growth assumptions can be presented as shown in table 1.
A couple of conclusions from Table 1.
Because company A does not have a higher return on capital than the required rate of return (ROIC = CoE) they will not create any additional value no matter how much they manage to invest. For Company B, which creates value (ROIC > CoE), the question will be how much they manage to reinvest (b) for growth and how long they manage to reinvest for the high profitability. At the same time, investors will want as high a reinvestment rate (b) as possible if the ROIC is higher than the CoE. As mentioned above, higher ROIC is better than lower ROIC, because increasing ROIC means less reinvestment needs and higher free cash flow.
We can also separate the popular dichotomy “value” versus “growth”. Growth is always an element of value creation, but can contribute both positively and negatively, i.e. be both value-creating and value-destroying. It will therefore not be profitable to buy the cheapest company if there is no value creation there, it is actually priced correctly. As Buffett writes in Berkshire Hathaway’s 1992 shareholder letter: “Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive”. The answer to the initial question is that even if the two companies have the same growth and earn the same in kroner and øre, that means not that they should be valued at the same P/E multiple.
Be careful!
So the next time you are served a comparison of P/E numbers for companies, you should frown a little and ask: What return on capital do the companies have? How long and how much can they reinvest at a given profitability? In practice, investors will often assess the level of return on capital against the ability to reinvest. At a given level, a high return on capital is often “good enough” (provided that it can be maintained fairly over time), and then the companies’ ability and opportunities to reinvest, as well as how long the rate of reinvestment can be maintained, will be the most important thing.
As investment legend Charlie Munger sums it up: “There are two kinds of businesses: The first earns 12 percent, and you can take it out at the end of the year. The second earns 12 percent but all the excess cash must be reinvested—there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, ‘There’s all of my profit.’ We hate that kind of business.”
Tags: Cheapest
