The company makes about a 10% return on equity. That’s barely above the cost of capital. A business’s quality is pretty directly related to its ability to earn an above-market return on investment. If ROE = cost of capital, growth does not create any value. 9x EBIT is a pretty fair multiple for such a company. To believe this is undervalued, you have to believe return on capital is going to increase in the future. Is this the case?
Also, I wonder if there might be a contradiction in your assumptions. You assume 9% annual growth, but you also assume they dispose of the healthcare and technology businesses - is this factored into the 9% growth rate??
Hi Matt, thanks for your response. There's a few things in here so I'll try and answer each individually.
On the ROE point. I'm not sure that is right. I get ROE to be to have averaged in the mid-teens and currently sits at an all-time low of around 12%. I don't think comparing cost of capital to ROE is right tbh, I think we ought to be looking at cost of equity (which is itself a rather spurious concept).
Also, the ROE I quote is conservative form, I would typically ex out amortisation of acqured intangibles from this, which raises the average to 18% and the current to 15%.
Though, I prefer return on capital, which I use the harshest measure for, which I believe is NOPAT/Invested Capital. On this measure, we are currently sitting at 9% compared to an average c. 12%. I admit these aren't spectacularly high but they do a allow for a handsome rate of return when compounded.
Part of the bull case is that there is an assumption that the currently low levels are an aberation and actually the long-term averages are closer to what it should/can be making if everything goes right.
I don't really know what the right EV/EBIT multiple for a give ROE is, although it should be noted that they are inextricably linked since a high valuation is the inversion of a low cost of captial and vice-versa. In other words, a company trading on a EV/EBIT of 20x for example, necessarily has a COE of that is half that of one on 10x.
For the growth rate, yes I have adjusted it in the internal calculations but I'm seeking to provide a narrartive case that is understandable to the lay investor and provide a flavour for the assumptions. I'd be curious to know whether you think it worth filling out the appendix with more detail on the modelling side as I'm still trying to fine-tune my style.
The company makes about a 10% return on equity. That’s barely above the cost of capital. A business’s quality is pretty directly related to its ability to earn an above-market return on investment. If ROE = cost of capital, growth does not create any value. 9x EBIT is a pretty fair multiple for such a company. To believe this is undervalued, you have to believe return on capital is going to increase in the future. Is this the case?
Also, I wonder if there might be a contradiction in your assumptions. You assume 9% annual growth, but you also assume they dispose of the healthcare and technology businesses - is this factored into the 9% growth rate??
Hi Matt, thanks for your response. There's a few things in here so I'll try and answer each individually.
On the ROE point. I'm not sure that is right. I get ROE to be to have averaged in the mid-teens and currently sits at an all-time low of around 12%. I don't think comparing cost of capital to ROE is right tbh, I think we ought to be looking at cost of equity (which is itself a rather spurious concept).
Also, the ROE I quote is conservative form, I would typically ex out amortisation of acqured intangibles from this, which raises the average to 18% and the current to 15%.
Though, I prefer return on capital, which I use the harshest measure for, which I believe is NOPAT/Invested Capital. On this measure, we are currently sitting at 9% compared to an average c. 12%. I admit these aren't spectacularly high but they do a allow for a handsome rate of return when compounded.
Part of the bull case is that there is an assumption that the currently low levels are an aberation and actually the long-term averages are closer to what it should/can be making if everything goes right.
I don't really know what the right EV/EBIT multiple for a give ROE is, although it should be noted that they are inextricably linked since a high valuation is the inversion of a low cost of captial and vice-versa. In other words, a company trading on a EV/EBIT of 20x for example, necessarily has a COE of that is half that of one on 10x.
For the growth rate, yes I have adjusted it in the internal calculations but I'm seeking to provide a narrartive case that is understandable to the lay investor and provide a flavour for the assumptions. I'd be curious to know whether you think it worth filling out the appendix with more detail on the modelling side as I'm still trying to fine-tune my style.
Once again, thanks for your input
Best
Wonder Stocks