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".
