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