Markets all over the world put a premium on growth. Companies chase it and make it their holy grail. In the Indian stock market context, I took the top 50 high revenue growth stocks with a market cap of greater than 500 crores and found the average Price to Earning ratio was a whopping 80.84. Markets like growth stocks but should they? Let’s test this but first let me introduce some first principles of valuation.
Cost of Equity/Cost of Capital: A firm can generate capital from two sources debt and equity. The cost of equity is what equity investors expect to generate by investing in the company and the cost of debt is what lenders charge for providing capital. The cost of capital is the weighted average cost of debt and equity. Cost of debt depends on the profitability of the firm, the existing financial leverage and financial ratios like the interest coverage ratio. The lenders price the cost of debt to cover their risk of providing capital. But what about the cost of equity? This is the cost which you, the investors in the common stock of the company charge for investing in the company. This is the return that you expect to make. So how much should you expect? The short answer is your expectations of return should be directly proportional to the risk of investing in the firm. How to think about risk of investing in the firm is to classify it into two parts, diversifiable risk and systematic risk.
- Diversifiable risk: This is risk specific to a particular firm. For example, if a firm has corporate governance issues then that is a firm specific risk and can be nullified by diversification. While making investment decisions there are risks which range from affecting one company to one sector to the entire market. If you put all your money in one company then you are exposed to all the above mentioned risks. By diversifying you essentially reduce your level of risk to the level of the market. The spectrum of risk is illustrated in the figure below:
- Systematic Risk: These are the risks which affect the entire market and no amount of diversification in stocks can protect you from it. Diversification in other asset classes like gold etc. can help but we won’t go into that here. The measure of systematic risk is measured by beta (β) and it measures the covariance of the return on the asset with the market return divided by the variance of the market return. A well diversified portfolio should have a beta of 1.
Coming back to the cost of equity, the cost of equity should compensate investors for the systematic risk (non diversifiable risk) they take when they invest in the stock and is given by:
Cost of Equity=Risk Free Rate + β*(Equity Risk Premium)
The risk free rate is the latest ten year government bond yield for all practical purposes and the equity risk premium is the premium investors charge for choosing to invest in equities rather than the much safer government bond. This figure can range from 4-5% depending upon the risk free rate. Beta is generally calculated through a regression and it depends on the following factors:
- Operating Leverage: The higher the fixed costs relative to variable costs, the greater the systematic risk. In the coronavirus crisis, manufacturing companies with higher fixed costs have been hurt more than others and hence have a higher beta.
- Financial Leverage: High debt to equity firms are riskier than low debt to equity firms and consequently will have a higher beta
- Discretionary spending: To the extent that consumers can do without a company’s products and services, the company will have a higher beta. This is why pharmaceutical companies will always have a low beta of less than one unless they have high financial leverage.
Now that we have established the cost of equity and cost of capital let’s look at returns.
Return on Equity/Return on Capital: Return on equity is the return that equity investors receive on their investment and return on capital is the return generated at the level of the firm for both debt and equity investors.
What is value?
Value can have many definitions but for equity investors value has one central theme. A firm must generate a return on equity/capital greater than the cost of equity/capital. Firms that do this create value for investors and firms that don’t destroy value for their investors. Growth is valuable only if the return on equity is greater than the cost of equity otherwise growth can destroy value rather than generate value. Let’s look at how in the following case study.
Case Study: ITC Hotels Business
People who follow me know that I do company valuations and recently I valued ITC (https://wisdomofcrowds.in/2020/08/11/itc-sum-of-parts-valuation/). I want to dig deep into the hotel business to illustrate the value of growth. If you look at the industry even before the coronavirus it is plagued with low margins and low return on invested capital/equity. ITC is no different with the operating margin at 8.5% and return on invested capital at around 2%. This is because this business is an asset heavy business and requires significant reinvestment. I did my valuation for ITC predicting the following:
- Business to grow at 10% CAGR for the next ten years
- Operating profit margin to increase to 14% from 8.5%
- Return on Invested capital to increase to 12% from 2.15%
I used the sales to capital ratio to estimate my reinvestment and got the following result:
My value for the hotel business is negative even though the company is profitable and will increase profitability in the future. So why is my value negative? Since ITC has almost no debt, my return on capital and cost of capital are basically also my return on equity and cost of equity. Now the cost of equity that I estimate for the hotel business is fairly high. This is because my estimated beta is 1.35. The high beta is largely because of the high operating leverage and the discretionary nature of the services offered. Since the return on equity/capital is less than the cost of equity/capital the business creates very little value for investors.
Now take a second scenario. Let’s assume the business has zero growth in the next ten years. The valuation sheet in this scenario is given below:
The value is still a low number but at least it’s positive. The value of operating assets increases by around 1300 crores just by not growing and focusing on increasing efficiency. If your company can’t generate excess returns i.e. generate a return on equity/capital greater than the cost of equity/capital then the more it grows the more it destroys value for investors. In India, 56% of all listed firms cannot generate excess returns. Globally, 58% of all listed firms cannot make their cost of capital. I am attaching my valuation sheet below so that everyone can play with the numbers and see for themselves.
This is not a rule of thumb. Young firms cannot make excess returns initially and understandably so. They need to grow to establish a foothold in the market. Even companies like Amazon earned very little profit on a lot of their businesses for many years. But the difference was the vision. The end game was fairly visible. They were growing customers and driving out the competition while achieving a scale which would be very hard to compete in the future. Many technology companies acquire users with the optionality of increasing profitability in the future as they achieve significant scale. All this is fine and if you can see a vision for your company where things will change in the future then it might be good to wait and watch. But if there is no endgame in sight then it is best to ask the question “Is growth creating or destroying value for my business?”