Decomposing ROE Aswath Damodaran 22 Assume that you are analyzing a company

# Decomposing roe aswath damodaran 22 assume that you

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Decomposing ROE 22 Assume that you are analyzing a company with a 15% return on capital, an after-tax cost of debt of 5% and a book debt to equity ratio of 100%. Estimate the ROE for this company. Now assume that another company in the same sector has the same ROE as the company that you have just analyzed but no debt. Will these two firms have the same growth rates in earnings per share if they have the same dividend payout ratio? Will they have the same equity value? Aswath Damodaran
23 Estimating Growth in EBIT: Disney We started with the reinvestment rate that we computed from the 2013 financial statements: Reinvestment rate = We computed the reinvestment rate in prior years to ensure that the 2013 values were not unusual or outliers. We compute the return on capital, using operating income in 2013 and capital invested at the start of the year: Return on Capital 2013 = Disney’s return on capital has improved gradually over the last decade and has levelled off in the last two years. If Disney maintains its 2013 reinvestment rate and return on capital for the next five years, its growth rate will be 6.80 percent. Expected Growth Rate from Existing Fundamentals = 53.93% * 12.61% = 6.8% Aswath Damodaran
24 When everything is in flux: Changing growth and margins The elegant connection between reinvestment and growth in operating income breaks down, when you have a company in transition, where margins are changing over time. If that is the case, you have to estimate cash flows in three steps: Forecast revenue growth and revenues in future years, taking into account market potential and competition. Forecast a “target” margin in the future and a pathway from current margins to the target. Estimate reinvestment from revenues, using a sales to capital ratio (measuring the dollars of revenues you get from each dollar of investment). Aswath Damodaran 24