Earnings multiples aren't driven by growth alone

A high earnings multiple is commonly used to classify a stock as a growth stock (just look at what Jim Cramer from Mad Money writes). Growth is not the whole story. By looking at the key value driver formula, we can see that the earnings multiple is determined by growth and the return on invested capital (ROIC). Divide both sides of the formula with the net operating profit less adjusted taxes (NOPLAT) to get the earnings multiple.

• Value = (NOPLAT(1-g/ROIC))/(WACC-g)
• Divide both sides with NOPLAT
• Value/NOPLAT = (1-g/ROIC)/(WACC-g)
• As we can see, the earnings multiple on the left is a function of both growth and ROIC

The Key Value Driver Formula and the Zen of Corporate Finance

This post is a part of my series on valuation. Today, I look at the fundamental drivers of value in a business.


When valuing a company, there are two main factors to consider. The Return on Invested Capital (ROIC) and the growth in cash flows (g)

• Growth rate = return on new invested capital * investment rate
• ROIC = capital invested in the business = PPE + net working capital (typically)

If the growth remains constant in perpetuity, we can use the following formula to calculate the value of a company:

• Value = Free Cash Flow,t=1/(Cost of Capital - Growth)

The cost of capital can be substituted for the Weighted Average Cost of Capital (WACC)

Example: 

Earnings = 100
Net investment = 25
Cash Flow,t=1 = 75
Cost of Capital = 10%
Growth = 5%

Value = 75/(10%-5%) = 75/0.05 = 1500 

Based on this valuation, we can also calculate an implied earnings multiple:

• Earnings multiple = Valuation/Earnings = 1500/100 = 15X

The free cash flow is calculated as NOPLAT minus net investment. NOPLAT is Net Operating Profit Less Adjusted Taxes and represents the cash generated by the business in a given year. From this we can create what is called the key value driver formula:

• Value = (NOPLAT,t=1 * (1 - g / WACC)) / (WACC - g)

This article is based on the book Valuation by Koller, Goedhart & Wessel. They call the key value driver formula the Zen of Corporate Finance "because it relates a company's value to the fundamental drivers of economic value: growth , ROIC and the cost of capital".