Valuation Post 6: Drivers of Business valuation Basic Framework Part 1

Before we go deep into the drivers of valuations we have dedicated this blog post on some formulas which explains the interlinkages between few critical financial metrics & valuations of a company.

The Formula for growth in earnings is

EPS Growth = Retention Ratio * Return on Equity.

This is a PAT level growth formula and this also includes Non-operating/ Non core income.

To understand how this formula leads to correct interpretation of growth please see below table. An important assumption behind this formula is that the business does not raise any new equity, the only addition to equity happens due to retained Earnings or some direct entries in Other comprehensive income (OCI).

Retention Ratio used in above table is equal to

PAT - Preference Dividends (rarely seen in Indian companies) - Common dividends

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PAT

OR

1 - Dividend Payout Ratio (where: DP Ratio = Dividend per share/Earnings per share)

Note: For more detailed understanding on ROE, please visit our blog here

But we need to focus on core business & operating earnings without the impact of capital structure on earnings. Hence we need EBIT level growth. So we’ll use different formula which is:

NOPAT (Net operating profit after taxes) growth (in %) = Return On Invested Capital (in %) * Reinvestment Rate.

ROIC = NOPAT / Invested Capital

NOPAT = EBIT * (1 - t) or EBIT - Cash Taxes paid

Invested Capital (Core Operating Assets) = Core/Operating Fixed Assets (tangibles + intangibles + Right to use assets) + Working Capital

Note: For more detailed understanding on ROIC, please visit our blog here

if we reverse the formula we get:

Reinvestment Rate = growth in NOPAT / ROIC - It means basically what percentage of NOPAT will have to be reinvested into business to achieve the desired growth

As the entire world of discounted cash flow valuations revolves around Free cash flows (FCFs) we need to understand one of the most important ways to calculate FCF.

Note: For detailed understanding of Cash Flows please go through our blogs on Decoding Free Cash Flows.

For this section we will only focus on Free Cash Flows to the firm/Enterprise (FCFF).

The formula of FCFF through EBIT

FCFF = NOPAT + Depreciation - Net Capex - Working capital

As it is started from EBIT we won't be adding Interest to it. And if we combine (negative) Net capex and (negative) working capital then we can also write formulas as

FCFF: NOPAT + Depreciation - Reinvestments

Read our next blog on Drivers of Business valuation Basic Framework Part 2 to understand why the market awards different valuations even to similar looking businesses.

#Reinvestment_rate #FCFF_Formula #ROE_retention_equation