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IV.OperatingIncomeGrowthwhenReturnonCapitalisChanging

¨ Whenthereturnoncapitalischanging,therewillbeasecondcomponenttogrowth,positiveifthereturnoncapitalisincreasingandnegativeifthereturnoncapitalisdecreasing.

¨ IfROCt isthereturnoncapitalinperiodtandROCt+1 isthereturnoncapitalinperiodt+1,theexpectedgrowthrateinoperatingincomewillbe:

ExpectedGrowthRate=ROCt+1 *Reinvestmentrate+(ROCt+1 – ROCt)/ROCt

¨ Ifthechangeisovermultipleperiods,thesecondcomponentshouldbespreadoutovereachperiod.

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Motorola’sGrowthRate

¨ Motorola’scurrentreturnoncapitalis12.18%anditsreinvestmentrateis52.99%.

¨ WeexpectMotorola’sreturnoncapitaltoriseto17.22%overthenext5years(whichishalfwaytowardstheindustryaverage)ExpectedGrowthRate=ROCNewInvestments*ReinvestmentRateCurrent+{[1+(ROCIn5years-ROCCurrent)/ROCCurrent]1/5-1}=.1722*.5299+{[1+(.1722-.1218)/.1218]1/5-1}=.1629or16.29%

¨ OnewaytothinkaboutthisistodecomposeMotorola’sexpectedgrowthinto¤Growthfromnewinvestments:.1722*5299=9.12%¤Growthfrommoreefficientlyusingexistinginvestments:16.29%-9.12%=7.17%

NotethatIamassumingthatthenewinvestmentsstartmaking17.22%immediately,whileallowingforexistingassetstoimprovereturnsgradually

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TheValueofGrowth

Expected growth = Growth from new investments + Efficiency growth= Reinv Rate * ROC + (ROCt-ROCt-1)/ROCt-1

Assume that your cost of capital is 10%. As an investor, rank these firms in the order of most value growth to least value growth.

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TopDownGrowth

GrowthIV187

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EstimatingGrowthwhenOperatingIncomeisNegativeorMarginsarechanging

¨ Allofthefundamentalgrowthequationsassumethatthefirmhasareturnonequityorreturnoncapitalitcansustaininthelongterm.

¨ Whenoperatingincomeisnegativeormarginsareexpectedtochangeovertime,weuseathreestepprocesstoestimategrowth:¤ Estimategrowthratesinrevenuesovertime

n Determinethetotalmarket(givenyourbusinessmodel)andestimatethemarketsharethatyouthinkyourcompanywillearn.

n Decreasethegrowthrateasthefirmbecomeslargern Keeptrackofabsoluterevenuestomakesurethatthegrowthisfeasible

¤ Estimateexpectedoperatingmarginseachyearn Setatargetmarginthatthefirmwillmovetowardsn Adjustthecurrentmargintowardsthetargetmargin

¤ Estimatethecapitalthatneedstobeinvestedtogeneraterevenuegrowthandexpectedmarginsn Estimateasalestocapitalratiothatyouwillusetogeneratereinvestmentneeds

eachyear.

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TeslainJuly2015:GrowthandProfitability

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Tesla:ReinvestmentandProfitability

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Expected Growth Rate

Equity Earnings Operating Income

HistoricalFundamentalsAnalysts HistoricalFundamentals

Stable ROE Changing ROE

ROE * Retention RatioROEt+1*Retention Ratio+ (ROEt+1-ROEt)/ROEt

Stable ROC

ROC * Reinvestment Rate

Changing ROC

ROCt+1*Reinvestment Rate+ (ROCt+1-ROCt)/ROCt

Negative Earnings

1. Revenue Growth2. Operating Margins3. Reinvestment NeedsEarnings per share Net Income

Stable ROE Changing ROE

ROE * Equity Reinvestment Ratio

ROEt+1*Eq. Reinv Ratio+ (ROEt+1-ROEt)/ROEt

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CLOSUREINVALUATION

TheBigEnchilada

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GettingClosureinValuation

¨ Apubliclytradedfirmpotentiallyhasaninfinitelife.Thevalueisthereforethepresentvalueofcashflowsforever.

¨ Sincewecannotestimatecashflowsforever,weestimatecashflowsfora“growthperiod” andthenestimateaterminalvalue,tocapturethevalueattheendoftheperiod:

Value = CFt

(1+r)tt=1

t=∞∑

Value = CFt

(1+r)t+

Terminal Value(1+r)N

t=1

t=N∑

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WaysofEstimatingTerminalValue

Terminal Value

Liquidation Value

Multiple Approach Stable Growth Model

Most useful when assets are separable and marketable

Easiest approach but makes the valuation a relative valuation

Technically soundest, but requires that you make judgments about when the firm will grow at a stable rate which it can sustain forever, and the excess returns (if any) that it will earn during the period.

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1.Obeythegrowthcap

¨ Whenafirm’scashflowsgrowata“constant” rateforever,thepresentvalueofthosecashflowscanbewrittenas:Value=ExpectedCashFlowNextPeriod/(r- g)where,

r=Discountrate(CostofEquityorCostofCapital)g=Expectedgrowthrate

¨ Thestablegrowthratecannotexceedthegrowthrateoftheeconomybutitcanbesetlower.• Ifyouassumethattheeconomyiscomposedofhighgrowthandstablegrowthfirms,

thegrowthrateofthelatterwillprobablybelowerthanthegrowthrateoftheeconomy.

• Thestablegrowthratecanbenegative.Theterminalvaluewillbelowerandyouareassumingthatyourfirmwilldisappearovertime.

• Ifyouusenominalcashflows anddiscountrates,thegrowthrateshouldbenominalinthecurrencyinwhichthevaluationisdenominated.

¨ Onesimpleproxyforthenominalgrowthrateoftheeconomyistheriskfree rate.

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