Michael Mauboussin recently wrote a paper titled – The Math of Value and Growth in which he discusses how valuations change as assumptions about growth, return on incremental invested capital, and the discount rate vary. These changes are discussed in terms of P/E multiples and discounted cash flow models which drive the calculations. Here’s an excerpt from the paper:

Most investors value stocks using multiples, which tend to obscure the underlying drivers of value. Many investors also seek to distinguish between value and growth stocks, which are commonly sorted based on multiples of earnings or book value. The important drivers of value are opaque with these practices, and very few investors have a clear sense of how revisions in expectations for those drivers change multiples.

In particular, we focused on how changes in growth rates can affect P/E multiples, the idea that companies with substantial current investment opportunities that are attractive lengthen their duration, and why the distinction between growth and value is muddled.

While our core hypothetical examples assumed a business with very attractive economics, it is important to bear in mind that ROIICs eventually drift lower as a consequence of factors such as competition, maturation, obsolescence, and disruption.

Bruce Greenwald uses the example of an imaginary company called Top Toaster. Top Toaster’s high initial returns gradually drop as competitors come along and drive incremental returns toward the cost of capital.

Once ROIIC is equal to the cost of capital, Top Toaster will trade at the commodity multiple and an enterprise value equivalent to its invested capital. This is in the future of almost all companies. Sometimes this reality is near and sometimes it’s distant. To bring the point home, Greenwald says, “In the long run, everything is a toaster.”

You can read the entire paper here: Michael Mauboussin – The Math of Value and Growth.

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