Comparison of Three Companies with Different Levels of Profitability

Analysis of Profitability and Growth Potential

1)The question below asks you to compare 3 companies from the same industry with differing levels of profitability and similar costs of capital. 

Company A Company B Company C

ROIC4.0%6.0%8.0%

ROE 4.0% 8.0%            12.0%

WACC 6.0% 6.0% 6.0%

Cost of Equity 8.0% 8.0% 8.0%

Sustainable Growth 3.0% 2.0% 1.0%

Invested Capital $10m $10m $10m

Book Value Per Share $5.00 $5.00 $5.00

P/E Ratio 19.4 12.3    9.8

P/B Ratio   0.8    1.0    1.2

Dividend Yield 1.4% 6.2% 8.5%

a)Which of these companies should we be willing to pay the most for, and why?

b)Which of these companies is likely to benefit from growth, and which of these companies will be harmed by growth?  Explain your reasoning.

c)Which of these companies appears to offer the best investment opportunity based  on the combination of profitability, growth, and valuation characteristics above? Explain your reasoning carefully here; how did you arrive at this conclusion?

2)Let’s begin by looking at the profitability & growth characteristics of the company described in Tab #1 and exploring how they translate to an estimate of value.

a)What are the ROIC & ROE, and how do they compare against its WACC and/or cost of equity? Do they appear to suggest that this company has a competitive advantage?  

b)Now fill in the cash flow forecasts for the forecast year; what is your estimate for Free Cash Flow to Available to Shareholders in 2020, and why are we predicting a such a significant change vs the prior year?

c)Build out the valuation section at the bottom of the model by using the perpetuity formula to value this company’s cash flows. How much should we be willing to pay for one share of this company’s stock if we think its profitability is sustainable and it can grow by 2% per year forever? 

d)Notice how optimistic this assumption is:  we’re predicting that this company can sustain an ROIC that is higher than its WACC forever. Examine how this belief affected your estimate by changing your assumptions so that ROIC = WACC in 2020; how much did this change your estimated value, and the P/E and P/B ratios that it implies?

e)Would you be willing to pay $30 per share for this stock if you think the company can maintain its current profitability forever?  Would your answer change if you thought the company was about to lose its competitive advantage?

3)Now move to Tab #2:  it lets us explore a third possibility that the company might lose its competitive advantage gradually, over time.  Build in this expectation by changing the assumptions in your forecast so that the ROIC gradually declines over the forecast period and ROIC = WACC in the final year of the model.  

How much should we be willing to pay for one share of this company’s stock if we think its profitability will fade gradually over the next 5 years? 

4)Now move to Tab #3: it lets you explore how the value would change if it takes the company 10 years to lose its competitive advantage.  Re-run your estimates and comment on how a longer “competitive advantage period” affected your estimates.

5)Notice that we’ve added a new dimension to our analysis: the length of a company’s “competitive advantage period” will affect our estimate as well.  

Company A Company B Company C

ROIC8.0%8.0%8.0%

ROE            12.0%            12.0%            12.0%

WACC 6.0% 6.0% 6.0%

Cost of Equity 8.0% 8.0% 8.0%

Sustainable Growth 2.0% 2.0% 2.0%

Invested Capital $10m $10m $10m

Book Value Per Share $5.00 $5.00 $5.00

P/E Ratio   8.5    8.5    8.5

P/B Ratio   1.0    1.0    1.0

“Competitive Advantage 20 years 10 years 5 years

   Period”

a)Which of these companies should we be willing to pay the most for, and why?

b)Which of these companies appear to be good investment opportunities based on the combination of profitability, growth, and valuation characteristics above? Explain your reasoning.