I always thought I was a bit more valuation focused than the average investor, and this likely results from my academic studies which was quite focused on methods. Sure, no science at all, but art and so forth, but some simple truths are important …

Mauboussin publishes very good papers on valuation. The relevant paper is to be found here. It includes a table of fair P/E multiples as a function of (earnings) growth and ROIC. The lower the ROIC, the lower the dividend payout ratio, for given growth levels. Further, needed assumptions are cost of capital, and the period for excess returns (ROIC>COC). A simple assumption would be to choose a period of T years, for excess returns, and assuming no excess returns thereafter (ROIC=COC), which simply means, that growth thereafter adds no value.

A simple excel file is suffice to (re-)produce fair P/E multiples, and helps to understand the topic of value creation and value drivers.

earnings/EPS grow for the assumed period with the growth rate (g)

g and ROIC dictate the dividend payout with DPS(t) = EPS(t) x (1 – g/ROIC)

net present value (NPV) of dividends until T NPV(DVP) is the first term of fair value (FV)

the second term results from the terminal value which is always 12.5x here (1/COC = 1/8%) in year T, discounted to today NPV(TV)

(My results do not equal his, but are close, depending on either using current or fwd EPS)

5 thoughts on “Fair P/E multiples as a function of Growth and ROIC”

Love the idea about PE based on ROIC and earnings growth. Yet the values in the table seem to be rather low – or in other words: current markets would still be pretty overvalued.

Plus: Can you point to what role risk-free rates play in this valuation model? I mean, it makes a difference if you have 2% or 5% US-government 10y bonds, doesn’t it?

Discount rate (Dr) is, academically speaking, a function of appropriate risk free rates (rfr) and (equity) risk premia, so, yes, higher rfr result in higher dr if constant eqp assumed

Yeah, have to check the calculation – didn’t see it. Would be great to have a function on the different discount rates. Currently vs. last year, the difference in discounted cashflows must be enormous for long duration assets….

Love the idea about PE based on ROIC and earnings growth. Yet the values in the table seem to be rather low – or in other words: current markets would still be pretty overvalued.

Plus: Can you point to what role risk-free rates play in this valuation model? I mean, it makes a difference if you have 2% or 5% US-government 10y bonds, doesn’t it?

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Discount rate (Dr) is, academically speaking, a function of appropriate risk free rates (rfr) and (equity) risk premia, so, yes, higher rfr result in higher dr if constant eqp assumed

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Regarding low values: remember the fine print: 15yrs!

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Thanks!

Yeah, have to check the calculation – didn’t see it. Would be great to have a function on the different discount rates. Currently vs. last year, the difference in discounted cashflows must be enormous for long duration assets….

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I will send it to you (probably somewhere a small error, thus the deviations)

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