The Math We start by calibrating our discounted cash flow model with inputs that yield a P/E multiple in the low 30s. Here are the definitions and the initial assumptions: • • • We assume net operating profit after tax (NOPAT) will grow 10 percent per annum. NOPAT represents the cash profits a company would earn if it had no financial leverage. We assume a return on incremental invested capital (ROIIC) of 20 percent. ROIIC is defined as the change in NOPAT from this year to next year divided by this year's investment. For example, if NOPAT grows by $10 next year and the company invests $50 this year, the ROIIC is 20 percent (10/50). Note that it does not matter if the investment is expensed or capitalized, save for some effect on taxes. We assume the cost of equity capital to be 6.7 percent, which was Aswath Damodaran's estimate as of February 1, 2020. The cost of equity measures the return an investor expects to earn given the assumed risk. As such, the figure is the sum of the risk-free rate of 1.5 percent and an estimated equity risk premium of 5.2 percent. We assume the company is financed solely with equity for simplicity. Adding debt makes the calculations slightly more cumbersome but does not change the story. The model values explicit cash flows for 15 years after which it uses a perpetuity to estimate the residual value. Specifically, the model takes NOPAT in year 16, which reflects the benefit of the investment made in year 15, and capitalizes it by the cost of equity. That figure is then discounted to a present value. © 2024 Morgan Stanley. All rights reserved. 3794236 Exp. 8/31/2025 5 Morgan Stanley | INVESTMENT MANAGEMENT COUNTERPOINT GLOBAL Here's a summary of the inputs and the output: NOPAT growth: 10% ROIIC: 20% Cost of capital: 6.7% P/E: 32.3 If we increase the growth rate to 15 percent and hold everything else constant, we get this result: NOPAT growth: 15% ROIIC: Cost of capital: 20% 6.7% P/E: 52.2 We will now change these assumptions to see what the impact is on the P/E multiple. Because most investors who use multiples do not contemplate foundational assumptions, the changes are larger than they generally expect. Growth. Let's start by reducing the growth rate from 10 percent to 7 percent. We'll assume the base year earnings are $100. Growth 10% →7% Next year's earnings P/E Before $110 After $107 Before After 32.3 24.9 Note that the change in growth reduces next year's earnings by only 2.7 percent, but that the warranted P/E multiple drops a more precipitous 22.9 percent. Investors often calculate the P/E multiple using the current price and next year's earnings. As a result, they sometimes believe that the market overreacts to what appear to be modest changes in the near-term earnings. But if expectations for the trajectory of growth really do shift down, the large apparent drop in the P/E multiple is completely justified.

The Math We start by calibrating our discounted cash flow model with inputs that yield a P/E multiple in the low 30s. Here are the definitions and the initial assumptions: • • • We assume net operating profit after tax (NOPAT) will grow 10 percent per annum. NOPAT represents the cash profits a company would earn if it had no financial leverage. We assume a return on incremental invested capital (ROIIC) of 20 percent. ROIIC is defined as the change in NOPAT from this year to next year divided by this year's investment. For example, if NOPAT grows by $10 next year and the company invests $50 this year, the ROIIC is 20 percent (10/50). Note that it does not matter if the investment is expensed or capitalized, save for some effect on taxes. We assume the cost of equity capital to be 6.7 percent, which was Aswath Damodaran's estimate as of February 1, 2020. The cost of equity measures the return an investor expects to earn given the assumed risk. As such, the figure is the sum of the risk-free rate of 1.5 percent and an estimated equity risk premium of 5.2 percent. We assume the company is financed solely with equity for simplicity. Adding debt makes the calculations slightly more cumbersome but does not change the story. The model values explicit cash flows for 15 years after which it uses a perpetuity to estimate the residual value. Specifically, the model takes NOPAT in year 16, which reflects the benefit of the investment made in year 15, and capitalizes it by the cost of equity. That figure is then discounted to a present value. © 2024 Morgan Stanley. All rights reserved. 3794236 Exp. 8/31/2025 5 Morgan Stanley | INVESTMENT MANAGEMENT COUNTERPOINT GLOBAL Here's a summary of the inputs and the output: NOPAT growth: 10% ROIIC: 20% Cost of capital: 6.7% P/E: 32.3 If we increase the growth rate to 15 percent and hold everything else constant, we get this result: NOPAT growth: 15% ROIIC: Cost of capital: 20% 6.7% P/E: 52.2 We will now change these assumptions to see what the impact is on the P/E multiple. Because most investors who use multiples do not contemplate foundational assumptions, the changes are larger than they generally expect. Growth. Let's start by reducing the growth rate from 10 percent to 7 percent. We'll assume the base year earnings are $100. Growth 10% →7% Next year's earnings P/E Before $110 After $107 Before After 32.3 24.9 Note that the change in growth reduces next year's earnings by only 2.7 percent, but that the warranted P/E multiple drops a more precipitous 22.9 percent. Investors often calculate the P/E multiple using the current price and next year's earnings. As a result, they sometimes believe that the market overreacts to what appear to be modest changes in the near-term earnings. But if expectations for the trajectory of growth really do shift down, the large apparent drop in the P/E multiple is completely justified.

Financial Management: Theory & Practice

16th Edition

ISBN:9781337909730

Author:Brigham

Publisher:Brigham

Chapter7: Corporate Valuation And Stock Valuation

Section: Chapter Questions

Problem 25SP: Start with the partial model in the file Ch07 P25 Build a Model.xlsx on the textbook’s Web site....

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