Expected Growth in EBIT =.5(18.69%) = 9.35% n The forecasted reinvestment rate is much higher than the actual reinvestment rate in 1996, because it includes projected acquisition. Between 1992 and 1996, adding in the Capital Cities acquisition to all capital expenditures would have yielded a reinvestment rate of roughly 50%.
Aswath Damodaran 35 The No Net Cap Ex Assumption n Many analysts assume that capital expenditures offset depreciation, when doing valuation. Is it an appropriate assumption to make for a high growth firm? o Yes o No n If the net cap ex is zero and there are no working capital requirements, what should the expected growth rate be?
Aswath Damodaran 36 Return on Capital, Profit Margin and Asset Turnover n Return on Capital = EBIT (1-t) / Total Assets = [EBIT (1-t) / Sales] * [Sales/Total Assets] = After-tax Operating Margin * Asset Turnover n Thus, a firm can improve its return on capital in one of two ways: • It can increase its after-tax operating margin • It can improve its asset turnover, by selling more of the same asset base n This is a useful way of thinking about • choosing between a low-price, high-volume strategy and a high-price, lower-volume strategy • the decision of whether to change price levels (decrease or increase) and the resulting effect on volume
Aswath Damodaran 37 Firm Characteristics as Growth Changes Variable High Growth Firms tend to Stable Growth Firms tend to Risk be above-average risk be average risk Dividend Payout pay little or no dividends pay high dividends Net Cap Ex have high net cap ex have low net cap ex Return on Capital earn high ROC (excess return) earn ROC closer to WACC Leverage have little or no debt higher leverage
Aswath Damodaran 38 Estimating Stable Growth Inputs n Start with the fundamentals: • Profitability measures such as return on equity and capital, in stable growth, can be estimated by looking at – industry averages for these measure, in which case we assume that this firm in stable growth will look like the average firm in the industry – cost of equity and capital, in which case we assume that the firm will stop earning excess returns on its projects as a result of competition. • Leverage is a tougher call. While industry averages can be used here as well, it depends upon how entrenched current management is and whether they are stubborn about their policy on leverage (If they are, use current leverage; if they are not; use industry averages) n Use the relationship between growth and fundamentals to estimate payout and net capital expenditures.
Aswath Damodaran 39 Estimate Stable Period Payout g EPS = Retained Earnings t-1 / NI t-1 * ROE = Retention Ratio * ROE = b * ROE n Moving terms around, Retention Ratio = g EPS / ROE Payout Ratio = 1 - Retention Ratio = 1 - g EPS / ROE
Aswath Damodaran 40 Estimating Stable Period Net Cap Ex g EBIT = (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC = Reinvestment Rate * ROC n Moving terms around, Reinvestment Rate = g EBIT / Return on Capital n For instance, assume that Disney in stable growth will grow 5% and that its return on capital in stable growth will be 16%. The
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