Tuesday, May 29, 2012

How much are you paying for growth?

The debate about Facebook’s valuation is interesting on many dimensions, but one that is worth focusing on is how much growth is worth, and what you are paying for it. At one extreme are some value investors who argue that growth is “speculative” and that it is  worth very little or nothing. At the other are those who argue that growth is priceless and that you should therefore be willing to pay a “fortune” for it. Both groups seem to be in agreement that valuing growth is pointless, because it requires estimates that will be wrong in hindsight.  I had a series of posts on growth a few months ago looking at the limits of growth, the scaling up of growth, the value of growth and how management credibility affects that value. In this post, I offer a simple technique for assessing how much you are paying for growth in a company. In the next one, I address how to value that growth.

Growth Assets and Assets in Place
To provide a perspective on how growth and value interact, it is best to start with what I would call a financial balance sheet.

While it is structured like an accounting balance sheet, it is different on two counts. First, rather than break assets down into fixed, current and financial assets, as accounting balance sheets do, assets are broken down into two categories: “assets in place”, representing the value of investments already made and “growth assets”, measuring the value added by expected future growth. Second, accounting balance sheets are rooted in the past, with numbers representing capital originally invested in assets, whereas financial balance sheets are forward looking, with the values of these assets being based on their capacity to generate cash flows or on market values.

The value of assets in place
To understand the price you are paying for growth, consider a simple experiment. A business that has existing assets that are generating earnings has two choices. It can pay the entire income out to claimholders (as dividends to stockholders and interest to lenders ) and forsake future growth. Alternatively, it can reinvest some (or all) of its earnings back into new investments and generate growth for the future. If you adopt the no growth alternative, your earnings from the most recent period will be your cash flow each year in perpetuity.  The value of these cash flows can be computed by discounting back at a cost of capital to yield a value for assets in place:
Value of assets in place = After-tax Operating Income from most recent period/ Cost of capital
Note that the depreciation & amortization from the most recent period is reinvested back into the business to keep its earnings power intact.

There are only three estimation inputs that you need to derive this value. The first is the operating income. While it is convenient to use the operating income from the most resent year as the base value, you may choose to use an average over a few years for cyclical and commodity companies. The second is the tax rate. Again, while the effective tax rate is the easiest to access, you may decide to replace it with a marginal tax rate, if you feel that the company will revert to that rate over time. The third is the cost of capital. While you can compute the cost of capital for the firm in question, it may be far simpler to use the average cost of capital for the sector in which the firm operates. There is one variant worth considering. If you feel that the assets of the face obsolescence, you may decide to assume that the earnings from these assets will be available only for a finite period rather than forever. The equation for value of assets in place has to be modified to be an annuity, instead of a perpetuity.

Price paid for growth: DCF
Once you have derived a value for assets in place, you can estimate what you are paying for growth by looking at the traded value of the firm, computed as the enterprise value of the business (market value of equity plus debt minus cash). The difference between the traded enterprise value and the value of the assets in place can be considered the price paid for growth.

In the table below, we look at four firms, Microsoft, Kraft, Google and Linkedin, to illustrate this concept.

For each firm, we report the after-tax operating income and the cost of capital used to derive the value of the assets in place. By comparing this number to the enterprise value of the firm, we then compute, on a percent basis, the proportion of the price that goes towards growth.  What are we to make of these numbers? For Microsoft, you can justify the entire market value of the firm with the value of just assets in place.  For Kraft and Google, about 40% of the price paid is for expected future growth. For Linkedin, it is almost 99% of the value. Does the fact that Microsoft's entire value is justified by assets in place make it  a better investment than Linkedin? Not necessarily, since we have not valued growth explicitly and growth can destroy value. In my next post, I will look at the value of growth at each of these companies and consequences for investors who have paid much higher prices.

Note that this entire analysis can also be done in purely equity terms, with net income divided by cost of equity to derive the growth value in equity in assets in place. If you do so, you can compare the market capitalization (rather than enterprise value) of the firm to the assets in place. The difference will be the price paid for growth.

Price paid for growth: Relative valuation
High growth companies often trade at high multiples of earnings, book value or revenues and the “premium’ is usually justified as the price for growth.  This premium can be in enterprise value multiples, such as EV/EBITDA, EV/Sales or EV/Invested capital:
EV growth premium = Actual EV multiple - EV multiple for assets in place
With Google, for instance, the EV/EBIT multiple for just assets in place can be computed to be 7.90, obtained by dividing the intrinsic value of assets in place ($92,761 million) by the operating income ($11,742 million). It's actual EV/EBIT multiple is 13.01, estimated by dividing the actual enterprise value of $152,784 million by the same operating income. The growth premium in the EV/EBIT multiple is therefore 5.11 (13.01- 7.90).

The premium can also be stated in terms of price earnings ratios, as the difference between the PE ratio that you actually pay compared to the PE ratio that you would pay for just the assets in place.
PE premium = Actual PE ratio - PE ratio for assets in place
You can estimate the PE ratio for assets in place, either from the cost of equity directly (PE ratio for assets in place = 1/ Cost of equity) or by backing the equity value from the intrinsic value of assets in place (and subtracting out the debt and adding back cash). Using Google as an example again (with debt of $4,204 million, cash of $44,460 million and net income of $9,737 million):
Intrinsic value of equity in assets in place = $ 92,761 - $4,204 + $ 44,460 = $132,818
PE for assets in place = $132,818/ $9,737 = 13.64
Actual PE = $192,840/$9,737 = 19.80
Growth premium in PE = 19.80 - 13.64 = 6.26


  1. I am trying to match your data for MSFT and am having trouble reaching your EV. I roughly calculated market cap to be $223.4M from 8,593M shares @ $26.00 and 11,921M Debt with 9,160M cash. giving a EV of $226M.

  2. Add the short term investments to the cash. Their cash balance is much higher than $ 9 billion.

  3. Lovin your new blog entries....I read while havin breakfast and I skipped the morning paper afterwords.

  4. Much better, thanks Aswath.

  5. Dear Aswath,

    The difference between EV and the Intrinsic value as calculated by you is also encompassing non operating assets and liabilities, so it does not solely indicate price paid for growth. Have you considered that? Thanks

  6. What non-operating assets do you have in mind? The only ones that should matter are holdings in other companies and none of these firms have significant financial investments in other companies.

  7. I was more talking in general terms without referring to those examples. In terms of non operating assets/liabilities I was indeed thinking about investments in other firms but also such items as deferred taxes, pension assets/liabilities. Great posts by the way. Thank you

  8. Hey, just found this blog and I love it.

    I wonder what long term stable growth rate you use in the spread sheet, and how you adjust the long term ROC? Or do you simply assume 0% stable growth, so that you dont have to adjust the ROC?


  9. I set a stable growth rate = risk free rate and I leave your ROC at the existing level. I considered setting the ROC = Cost of capital, but I decided not to complicate life too much.

  10. I set a stable growth rate = risk free rate and I leave your ROC at the existing level. I considered setting the ROC = Cost of capital, but I decided not to complicate life too much.

  11. I would suggest doing the same exercise for the Indian cement companies

  12. really good calculated but i think it doesn't need so much...

  13. cover your interest expenses/foregone interest income, the future earnings will comfortably. It is therefore entirely possible for an accretive deal to be value destroying and a dilutive deal to be value increasing. matawan income tax services

  14. Growth stock investing is high risk. Value investing is buying stock in a company thats really worth 20 dollars for only 10 dollars. This is the reverse of growth stock investing which is based on buying the future expectations of a company.

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