Question

You are preparing a valuation for a high growth company, Winks Inc. This question concerns the estimation of graduation value. Winks operates in the high-tech waste disposal business. The average mature company in this industry have the following characteristics: Return on equity (most companies in this fictitious industry are all-equity) is 12%; the average mature firm reinvests 55% of net income back into its business; and the cost of equity for the average mature firm is 10%. During its first year of maturity (the first year after graduation), the company is forecast to earn $56M (net earnings).

A)What is the graduation value for the company(measured at date of graduation NOT today)?

B)Management of the company believes it can earn a better than average 13% return on equity, BUT this will require a higher reinvestment rate of 60%. Is this a good strategy (assuming the company is still forecast to earn $56M)?

Answer 1

Fundamentals

Free Cash Flow (FCF) = Net Income (NI) - Reinvestment (R)

Where, Reinvestment = Net Income * reinvestment rate =NI * IR

So, FCF = NI - NI*R = NI * (1-IR) .................................. Eq 1

Now, Long term Growth (g) = ROE * IR ..........................Eq 2

So from Eq 1

FCF - NI * (1 - g/ROE)

=> Value = FCF / (Cost of Capital - g)

Value = NI *(1-g/ROE) / (Cost of Capital - g) ................................ Eq 3

Now, as per the problem statement -

ROE = 12%

Cost of Capital = 10%

IR = 55%

NI = $56mn

So from Eq 2 => g = 12%*55% = 6.6%

From Eq 3 => Value= 56 *(1-6.6%/12%)/(10%-6.6%) = $741.18mn

So Graduation Value for the company = Its continuing value as computed above = $741.18 mn................... Answer A

If IR = 60% & ROE = 13%

growth as per Equation 2 = 13%*60% = 7.8%

Continuing value as per Equation 3 above will be

=> 56 *(1-7.8%/13%)/(10%-7.8%) = $1018.18mn

Using higher reinvestment is a good strategy as its increases the overall value of the company ............... Answer B