Suppose that earnings are $32. An analyst determines it would cost $20 to grow earnings by 10 percent forever. So you can have either:
· $32 forever with no growth, or,
· $12 ($32 - $20) growing at 10 percent forever.
Which is better, no growth or growth?
It depends on the cost of capital.
Use the following standard valuation formula:
V = D1 / (k-g)
This formula is a variation on the V = D/k when discussing current earnings, giving effect to same rate of growth designated by g.
Illustrations:
k=cost of capital=20%, 16% or 14%
g=growth=0% or 10%
Scenario 1: $32 forever with no growth
k=20%, 16% or 14% and g=0%
V=32/(0.20 – 0)= $160
V=32/(0.16 – 0)=$200
V=32/(0.14 – 0)= $229
Scenario 2: $12 ($32 - $20) growing at 10 percent forever.
k=20%, 16% or 14% and g=10%
V=12/(0.20 – 0.10)= $120
V=12/(0.16 – 0.10)=$200
V=12/(0.14 – 0.10)= $300
Note:
- The higher the cost of capital, the lower is the return on capital (valuation) and vice versa.
- With a 20-percent cost of capital, $32 forever with no growth ($160) is better than $12 growing at 10 percent forever ($120). Thus, growth subtracts value when the cost of capital exceeds the return on capital.
- With a 16-percent cost of capital, $32 forever with no growth ($200) is the same as that of $12 growing at 10 percent forever ($200). Growth is neutral to value when the cost of capital equals the return on capital.
- With a 14-percent cost of capital, $12 growing at 10 percent forever ($300) is better than $32 forever with no growth ($229). Thus, growth adds value when the return on capital exceeds the cost of capital.
When capital costs equal capital returns, growth neither adds nor subtracts value, no matter how much or how little growth there is. The reason is intuitive: If an investor putting in new capital charges the same rate that capital generates, then there is no additional return available to prior investors.
To come full circle, growth is not free.
- If a company can attract capital at a cost lower than returns it generates, growth adds value.
- If it attracts capital at a cost higher than what it generates, growth subtracts value.
- If the cost of capital is the same as the return on capital, growth is neutral to value.
The only businesses in the first category are those possessing franchise characteristics. The only way to capture returns on capital greater than the cost of capital is to keep competitors out. If competitors can get in, capital costs and returns will soon converge upon each other (or worse, capital costs will exceed capital returns).
Before turning to examining cash-flow based valuation techniques, note two crucial points:
(1) Assets drive earnings and cash flows, and
(2) Assets are analytically more important than either.
As to point (1):
- for most businesses, asset value exceeds earnings value;
- businesses whose earnings value exceeds asset value possess franchise characteristics. This implies the ability to sustain high returns on equity (high earnings relatives to net assets).
- data reliability varies.
- Balance sheet data tend to be most reliable for valuation exercises, then income statement data concerning current earnings.
- Properly estimated cash flows are probably less than earnings, though many contemporary analysts draw the opposite conclusion by ignoring important noncash charges to income such as depreciation.
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