Relationship between roic and multiple

All P/Es are not created equal | McKinsey

relationship between roic and multiple

Analysis of return on capital (ROIC), on the other hand, is usually buried in the Relative valuation should return the same P/S and P/E multiples. less than one 10th of one percent of the difference in price between stocks in the S&P For instance, the retailer Williams-Sonoma has a P/E multiple of about 21, based on The relationship between P/E multiples and growth is basic arithmetic:4 4. capital (ROIC), which is modestly higher than its 10 percent cost of capital. The following examples demonstrate the relationship between multiples and the key value drivers: ROIC and growth. The supporting tables.

Enterprise valuation multiples - a tale of two companies

This dynamic is what leads to high ROIC businesses trading at high PE multiples, even when they don't offer a lot of growth potential. Investors don't get a share of earnings, they get a share of distributable cash.

Since high ROIC businesses generate more distributable cash per dollar of earnings, their earnings are worth more to investors and thus their stocks are assigned higher PE ratios. So we see that PE ratios are driven by both growth and return on invested capital.

In our next post on this topic, we plan to show how high returns on capital persist for much longer periods of time than high growth rates, meaning that while both ROIC and growth generate value, high ROIC has a much more lasting impact. The Gordon model assumes that distributable cash is paid as a dividend, but by redefining D1 to distributable cash directly, we allow the model to generate consistent valuations whether a company uses excess cash generation to pay dividends, buy back stock, pay down debt or buy other companies.

This example ignores the impact of financial leverage. While this is below the market's historical average PE, it is in line with the unlevered multiple. The average company's ability to take on debt at a lower cost than equity reduces their cost of capital r in the Gordon model and increases their PE ratio.

The information contained in this post represents Ensemble Capital Management's general opinions and should not be construed as personalized or individualized investment advice.

Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one's entire initial investment.

If a security is mentioned in this post, you will find a disclosure regarding any position Ensemble Capital currently has in the security. Ensemble Capital is a discretionary investment manager and does not make "recommendations" of securities. Each quarter we file a 13F, which discloses all of our holdings.

What Is A Valuation Multiple?

To the extent the ROIC exceeds the cost of capital, the business creates value, and the faster it grows, the more value it creates. A business that has a ROIC that is less than the cost of capital destroys value, and the faster it grows, the more value it destroys.

A business that creates value commands a higher multiple for a given cost of capital. As to revenue, growth, and margins, improved margins generally translate to improve ROIC— provided the invested capital remains constant—save for reinvestment requirements. Margins must be improved to the point where the ROIC exceeds the cost of capital in order to create value.

Revenue growth is generally not the best way to improve margins except possibly in certain manufacturing situations where fixed costs are high; then again, high, fixed-cost industries bad economics can suffer brutal price competition margin erosionparticularly when overall demand is low. The following examples demonstrate the relationship between multiples and the key value drivers: The supporting tables employ a discounted net EBITDA analysis with a year discrete period and a default to three percent growth thereafter into perpetuity to determine a continuing value.

For the latter calculation, the reinvestment rate is computed using the three percent long-term growth assumption. Our hypothetical example companies are Southwest Widget and Midwest Gadget.

relationship between roic and multiple

If the cost of capital for SW is 20 percent remember the five timesthen SW has a value less than the value of its invested capital. The table below illustrates the SW situation: This deal is not going to happen with a 20 percent cost of capital and a 10 percent ROIC. In this case, the multiple is five as shown in the following table.

Enterprise valuation multiples | AMT Training

In a third scenario, assume SW is able to improve its ROIC to 30percent, 10 percent more than the cost of capital, and is able to grow at 15 percent per year. The difference in value is dramatic as indicated below: The multiple under this scenario is 7. High ROIC in high growth situations is the ideal combination for driving value. We put this idea of ROIC, cost of capital and growth together in the next table developed for a 20 percent that five again cost of capital under different growth and ROIC assumptions.

As in the above examples, each scenario runs for 15 years and then defaults to a 3 percent long-term growth rate thereafter. In the first column, the ROIC is less than the cost of capital. Increasing the growth simply destroys value and lowers the multiple even further to a theoretical negative 2.

  • All P/Es are not created equal
  • ROIC Vs. Growth: What Drives P/E Ratios?
  • Return on Invested Capital and Growth: M&A Multiple Drivers

In this situation, the ROIC needs to be fixed before any attempts at growth are undertaken. This scenario is ideal for distressed investors and turnaround types. In the second column, the company is earning the cost of capital; the ROIC and cost of capital are the same at 20 percent.

In this situation, a higher growth rate neither creates nor destroys value; it simply adds more zeros to the absolute numbers.

relationship between roic and multiple

So here is that magic five multiple appearing in every box, suggesting that many middle market companies valued at a five multiple are expected to earn at the EBITDA level the cost of capital at 20 percent, nothing more, nothing less. Smart sell-side investment bankers armed with the knowledge herein can effectively negotiate up from five, particularly in high-growth situations where the buyer is able to reduce costs through synergies and increase the ROIC.

The real exciting columns are the third and forth columns where the value is driven by an expected ROIC greater than the cost of capital, and the more it grows, the better it gets. These outcomes dramatically demonstrate the power of the primary multiple drivers, ROIC and growth.