Recently there was a news story. But before we get to that let's do a small exercise. We have some numbers from two firms in their respective, although unrelated, fields.
Which firm do you think is more valuable? May be we don't have complete information about their business, prospects and so forth. Yet, B should strike as more valuable, especially when we consider that B is in a stable, not declining, business.
As of now, the market value of equity of A is $347 b and that of B is $360 b. How did that happen?
Earnings are not better indicators of business value compared to cash flows. So let's check out the cash flows.
In the last three years, average cash flows to equity of A was $3.74 b while that of B was $20.28 b. Note that although these numbers have been taken from Yahoo Finance (for investment purposes I prefer to pick them from financial statements directly), they may not be far off. So let's move with them.
Has the market gone crazy? More often markets remain rational, but not always. Should we consider that this is one of those times?
May be A is into some sunshine business on the verge of disrupting the industry. May be A has much higher growth rate than B. May be. However, my aim is to find out under what circumstances should higher value for A be justified.
Let's assume that our expected return from equity is 10%, and also assume that cash flows are perpetual.
To get to their current market value, cash flows of A will have to grow at 8.92% annually, and those of B will have to grow at 4.36% in perpetuity.
If we lower the expected return to 8%, the growth rates for A will be 6.92% and for B 2.36%.
Even when we consider that it is a global market, not restricted to the US, growth rates of A appear to be stretched compared to B.
May be there is some time for A to reach stable period of growth. Let's assume that cash flows to firm go to equity holders in the absence of debt. What the heck is there to assume anyway?
I know that equating firm cash flows to equity is a bad idea. Let's correct it. If we assume two growth periods for A, free cash flows to equity to come to $7 b. This is how we get it: present value of average cash flows to equity of $3.74 b growing at 15% in the next 10 years at 8% cost of equity is $7 b, which is close to $7.3 b. A had revenues of $107 b in 2015; if they grow at 15% in the next 10 years, they would be $433 b in year 10. Walmart had revenues of $482 b in 2015. A would also require adequate reinvestment to achieve the required growth rate.
I know that equating firm cash flows to equity is a bad idea. Let's correct it. If we assume two growth periods for A, free cash flows to equity to come to $7 b. This is how we get it: present value of average cash flows to equity of $3.74 b growing at 15% in the next 10 years at 8% cost of equity is $7 b, which is close to $7.3 b. A had revenues of $107 b in 2015; if they grow at 15% in the next 10 years, they would be $433 b in year 10. Walmart had revenues of $482 b in 2015. A would also require adequate reinvestment to achieve the required growth rate.
Even when we consider free cash flows to equity of $7.33 b, A will have to grow them at 5.89% annually forever. Can A pull it off? Time will tell. For the moment though A has a story to tell for those who want to hear.
Is growth rate higher than 15% in the next 10 years sustainable for A? Its revenues grew annually at 29% in the last 5 years. What the heck, if we assume 25% growth rate in the next 10 years? This is how it would look:
Finally, we did it. If A grows at 25% in the next 10 years, and then at 3.34% in perpetuity, it could be valued at $347 b. For that A will have to achieve revenues of $996 b and free cash flows of 35 b in year 10. Is that possible? Time will tell. All I know is that growth does not come free; it needs reinvestment to sustain it, which we have not considered explicitly.
Is growth rate higher than 15% in the next 10 years sustainable for A? Its revenues grew annually at 29% in the last 5 years. What the heck, if we assume 25% growth rate in the next 10 years? This is how it would look:
Finally, we did it. If A grows at 25% in the next 10 years, and then at 3.34% in perpetuity, it could be valued at $347 b. For that A will have to achieve revenues of $996 b and free cash flows of 35 b in year 10. Is that possible? Time will tell. All I know is that growth does not come free; it needs reinvestment to sustain it, which we have not considered explicitly.
Market value of A's equity has been growing since long.
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