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What is the connection between IRR and growth rate?


scorpioncapital
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Say a company has IRR of 20% and another has IRR of 10%. I.e. they earn a certain amount on the amount they invest.

 

Let's say both companies grow at 10% and the initial yield (P/E ratio) is 5%.

 

After 5 years your return is 5% plus the incremental addition of 10% each year. That's sort of "your IRR" as an outside investor buying at a given share price.

 

But how is IRR, the internal efficiency of the company related to this external return and growth rate to you.

 

My intuition says the 20% IRR company is getting better returns on their investment. If they invest $1 and earn $1000 the returns are astronomical.

 

So is the contradiction here that the premise - 'both companies are growing at 10%' is false? Must higher IRR translate into higher growth rate?

 

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Both companies can grow at 10% if you assume the company with higher IRR (20%) has less investment opportunity than the company with lower IRR. I.e. the lower IRR company can put 2x the money to work.

 

LuxCo - High margin goods (high IRR) - lower volume, higher IRR

MassCo - Low margin goods (low IRR) - higher volume, lower IRR

 

Both can grow profits by the same amount per year. LuxCo can only invest 1K. MassCo can invest 2K.

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Ok, let's take it to the extreme. Why must any company be efficient? For example, why should a company care to be very careful to make good investments to get good returns?

 

I think Buffett gave an example. Let's throw 1 trillion at the problem. Suppose I could just get that money. And put it in the bank and earn 1%, I can say I made $10 billion in profit this year!

 

If there is no penalty for throwing money at anything and earning "something" (even if not much) what can we make of this?

 

The reason I ask is that I look at two companies in the same industry (or even different industries) where the inefficient one trades at a higher share price than the more efficient one because it decided to "merge and buy growth in earnings per share" or just threw a ton of money/debt at the problem.

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I believe you are conflating a lot of different things that should be taken apart and examined separately.

 

It would be way easier to sit down with you and go together through this example rather than to try writing wall of text and numbers here. So, sorry, but I pass on writing. :) Maybe someone else will take the challenge. :)

 

Edit: having a discussion based on market prices in abstract is meaningless. First of all, market may be wrong in valuing one or both companies. Second, market may be valuing things that you think are not important - but they might be.

 

In short, of course you'd rather have a $1M that produces $100K per year rather than $1K per year. But how much would you pay for the first vs the second? Would you really pay $500K (5P/E) for first and $5K for second? This ignores earnings stability, future proof'ness, etc. It also ignores what $1M is (cash? securities? a mine? a contract? 100 old trucks?) and whether it is easy/possible to make the second $1M earn much more than $1K per year.

 

Then you are introducing growth into the scenario and this complicates matters further, since you don't define what the growth is based on (earnings? sales? book value?) and what happens to the non-invested earnings/fcf.

 

I'll stop there. :)

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Say a company has IRR of 20% and another has IRR of 10%. I.e. they earn a certain amount on the amount they invest.

 

Let's say both companies grow at 10% and the initial yield (P/E ratio) is 5%.

 

Let's assume that by IRR, you mean ROE. In which case:

 

Company A needs to retain 50% of earnings to grow 10% per year. So you get 10% growth + 2.5% initial dividend yield

Company B needs to retain 100% of earnings to grow 10% per year. You get 0% yield.

 

The ROE determines your maximum sustainable growth rate. So Company A could potentially grow 20% per year (if they could find enough projects with 20% IRR). If Company B grew 10% per year forever, you would never get a single cent in dividends or buybacks.

 

--

BTW, if the discount rate is 10%, the growth at company B is creating no value. And it shouldn't be trading at 20x.

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Ok, let's take it to the extreme. Why must any company be efficient? For example, why should a company care to be very careful to make good investments to get good returns?

 

I think Buffett gave an example. Let's throw 1 trillion at the problem. Suppose I could just get that money. And put it in the bank and earn 1%, I can say I made $10 billion in profit this year!

 

If there is no penalty for throwing money at anything and earning "something" (even if not much) what can we make of this?

 

The reason I ask is that I look at two companies in the same industry (or even different industries) where the inefficient one trades at a higher share price than the more efficient one because it decided to "merge and buy growth in earnings per share" or just threw a ton of money/debt at the problem.

 

Look at MCHP's claim that their cost of capital on the Atmel acquisition is 1.8% per annum. I believe that they are doing what your hypothetical inefficient company is doing, which is to treat the cost of cash as the opportunity cost of keeping cash in treasuries. The problem here is that excess cash doesn't belong to the company, or rather, the company's cash belongs to the shareholders. The true cost of cash is the equity discount rate, which represents the shareholder's opportunity cost at the given level of risk.

 

The inefficient company theoretically should be punished for taking excess cash worth face value, and investing it at a lower rate of return than the equity discount rate. They are destroying value. But suppose that both companies have made it clear that neither is going to be returning capital to shareholders. The business that reinvests its cash into low returning investments is going to be more valuable than the company that just sits on it. I think there are a fair amount of companies that are punished valuation wise because it's clear that management has no plans to run the correct capital structure.

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Value = (FCF(1+k)/(k-g))/(1+r)

 

where FCF = Free cash flow at end of year 1, k = Return on Equity, g = growth rate, r = CAPM market rate of return.

You are mistaking Earnings for Free Cash Flow, IRR for Return on Equity, & not recognizing r.

 

Assume no change in FCF

k could be high because of high debt, operating leverage, or tax effects. Look up the DuPont breakdown.

g could be high simply because the base is small, versus lots of new business

r could be low because of QE efforts by local central banks. 

 

Assume FCF of 2, k = 10%, g = 8%, r = 3% ( A growth company in a 'risk off' market)

Value = (2(1.1)/(0.02))/(1.03) = 106.80.  A high valuation because its a growth stock.

 

Assume FCF of 5, k = 8%, g = 3%, r = 3% ( A more 'mature' company in a 'risk off' market)

Value = (5(1.08)/(0.05))/(1.03) = 104.83.  2.5x the FCF & a lower valuation - because it isn't growing.

 

Growth stock investment is all about understanding k-g; what's causing it, changing it, & its sustainability.

 

SD 

 

 

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Value = (FCF(1+k)/(k-g))/(1+r)

 

where FCF = Free cash flow at end of year 1, k = Return on Equity, g = growth rate, r = CAPM market rate of return.

You are mistaking Earnings for Free Cash Flow, IRR for Return on Equity, & not recognizing r.

 

Assume no change in FCF

k could be high because of high debt, operating leverage, or tax effects. Look up the DuPont breakdown.

g could be high because the base is small, versus lots of new business

r could be low because of QE efforts by local central banks. 

 

Assume FCF of 2, k = 10%, g = 8%, r = 3% ( A growth company in a 'risk off' market)

Value = (2(1.1)/(0.02))/(1.03) = 106.80.  A high valuation because its a growth stock.

 

Assume FCF of 5, k = 8%, g = 3%, r = 3% ( A more 'mature' company in a 'risk off' market)

Value = (5(1.08)/(0.05))/(1.03) = 104.83.  2.5x the FCF & a lower valuation - because it isn't growing.

 

Growth stock investment is all about understanding k-g; what's causing it, changing it, & its sustainability.

 

SD

 

That's it in a nutshell.  If you prefer 200 pages on this issue, take a look at McKinsey's Valuation treatise, which explains (and provides the math behind) the links between ROIC, growth rates and valuation ratios. 

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Fascinating discussion. I definitely feel there is some mispricing especially of cash rich companies.

 

I am intrigued by this quote,

 

"But suppose that both companies have made it clear that neither is going to be returning capital to shareholders. The business that reinvests its cash into low returning investments is going to be more valuable than the company that just sits on it. I think there are a fair amount of companies that are punished valuation wise because it's clear that management has no plans to run the correct capital structure."

 

This is exactly what I see happening! And it really feels like a who is swimming naked problem. That is, right now, you can't tell. Inefficiencies are being papered over. The incorrect capital structure company that is holding a ton of cash is being valued less than the reckless "investor" but only because we are in a liquidity drug zone kind of world.

 

I wonder truly if the wrong structure is ultimately the prudent one because you want to be where things are going not where they are now and pay dearly later for what seems just too easy. Almost feels like companies are chasing projects and returns just like investors are chasing stock prices up and up.

One company I follow earns 7.5% return on equity and another earns 20% ROE but the former is valued higher than the latter because they did an acquisition (with about a 5% IRR) , has higher absolute FCF/share due to the merger, and holds no cash (they used debt to finance it).

 

The question then becomes, given the crazy environment we are in - do you hold cash which you can only reinvest a portion at 20% or do you "plunge in" and buy everything in sight for 7% return just because rates are zero. Come to think of it, this is the private investor's problem too, not just a corporate problem :)

 

I'm going to be stubborn here and go with the cash hoarder and the superior return business just because it seems more forward thinking. I'll take the company that invests $100m and turns it into a $2 billion asset than the one that invests $2 billion asset to earn $100m. Meanwhile I'll watch the market give the low return business the higher valuation temporarily.

 

 

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Ok, let's take it to the extreme. Why must any company be efficient? For example, why should a company care to be very careful to make good investments to get good returns?

 

I think Buffett gave an example. Let's throw 1 trillion at the problem. Suppose I could just get that money. And put it in the bank and earn 1%, I can say I made $10 billion in profit this year!

 

If there is no penalty for throwing money at anything and earning "something" (even if not much) what can we make of this?

 

The reason I ask is that I look at two companies in the same industry (or even different industries) where the inefficient one trades at a higher share price than the more efficient one because it decided to "merge and buy growth in earnings per share" or just threw a ton of money/debt at the problem.

 

I've never found IRR that useful at the company level, I see it more as a marketing tool for companies like Valeant to pitch stupid capital allocation strategies.  Like DCF, IRR depends on the prediction of cash flows (unless it's a historical project which has already earned a positive return) - meaning it is useless without a crystal ball.  So let me answer this question a different way but with a CAPM flavor (which I don't totally agree or disagree with).  If you borrow 1T you are going to have some associated cost of capital.  If we assume that cost is "risk free," the only totally safe thing to do is take the cash and reinvest at the risk free rate.  But if you do that you're not earning anything.  So you need to take some risk to earn a return above your cost, and pocket the spread.  The trouble is your rate it no longer risk-free, which means you might earn a net negative return on capital.  So you might be losing money and/ or violating debt covenants a la your investment.  In fact, given a long enough period, you're guaranteed to do both of those things (like Valeant).  Owning the cash you invest ensures you don't get inordinately penalized for poor returns on invested capital or for loss of principal.

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