A Case Study on ROIC and Valuation Multiples.
A company's intrinsic value stretches deeper than simply high P/E = high growth and low P/E = low growth. ROIC can help us understand why.
I’ve always wondered how P/E (price-to-earnings ratios) ratios work conceptually. Do all SaaS (Software-as-a-service) companies trade at higher multiples just because they’re high growth? Why do some mature industries trade at higher multiples than others? They’re all mature, right? The reason can partially be related to a metric called ROIC (Return on Invested Capital).
What is ROIC?
The formula for ROIC is Net Operating Profit After Taxes (NOPAT) divided by total invested capital. NOPAT is exactly what it sounds like, calculated with EBIT * ( 1 - Tax Rate).
Invested capital refers to the total amount of money invested in a company by its shareholders, bondholders, and other financing sources to fund its operations and growth. Conceptually, invested capital represents the total resources available to a company for generating earnings and creating value for its stakeholders.
In the realm of finance, the definition of "invested capital" can vary depending on the context and the analytical requirements. In this article, we will define invested capital as the sum of a company's total debt and equity minus cash.
This method zeroes in on the capital actively employed in the business, excluding idle cash that might not directly contribute to operations or growth.
Why does ROIC matter?
Many of today’s investors have a simple thought process towards multiple valuations. It goes a little something like this: if a company has a high P/E, the company is high growth, and if a company has a low P/E it is low growth. Using ROIC, we can calculate and justify P/E ratios for certain businesses using cash flows. Let’s illustrate this by looking at Ann Arbor’s finest restaurant — Domino’s Pizza.
Case Study (Domino’s and Adobe)
In the past four years, Domino’s Pizza has grown revenue at an average growth rate of 2.89%.
Despite this performance, Domino’s has maintained an average P/E Ratio of ~35 and a P/S ratio of ~4. On the surface, this doesn’t make much sense. Domino’s Pizza is a mature QSR business known all around the U.S., yet it still trades at the P/E multiple of a SaaS business.
However, when we look at ROIC, things start to add up. From FY 2020 to FY 2023, Domino’s has posted an average ROIC of 33%1. Let’s say Domino’s, a mature company, wants to grow 5% a year. Think about what this means. This means Domino’s only needs to reinvest 15% of its cash flows (.33 * .15 = .05) to reach 5% growth per year. Thus, the remaining 85% of cash flow is distributable cash — meaning it can be allocated towards making shareholder’s equity more valuable (whether through share buybacks, debt paydown, dividend issuance, etc.).
Now, take a company like Adobe. ADBE 0.00%↑ is a software business that trades at a similar P/E ratio of ~30 and P/S of ~7 times.
Adobe has grown its revenue an average of 15% YOY, but Adobe’s average ROIC was only 27% from 2020 to 2023. If Adobe plans to maintain its growth rate, Adobe must reinvest 56% of its cash flows to sustain 15% growth.
(If Domino’s hypothetically wanted to grow 15%, it would only need to reinvest around 45% of its cash flows. )
To dig this example deeper, let’s assume Adobe wants to slow down and grow by 5%, just like Domino’s. In this case, Adobe would have to reinvest 18.5% of its cash flows compared to Domino’s 15%.
See how Domino’s ROIC leaves it with more distributable cash? ROIC measures how efficiently your investments generate profits.
Valuation
We can use the Gordon Growth Formula to work backward to an implied P/E multiple for Adobe and Domino’s.
In this model, D1 = Distributable Cash, or how much excess cash flow is left to be used in shareholder’s interests. For R, which is our cost of capital, we’ll use FactSet’s calculated WACC for both companies. DPZ 0.00%↑ has a calculated WACC of 7.2% (we’ll round up to 8 to account for today’s market) and ADBE 0.00%↑ has a WACC of 10.2%2. G is the company growth rate. For Domino’s, we’ll assume 5% into perpetuity due to its more mature nature, and for Adobe we’ll assume 8% due to its AI tailwinds and plethora of future SaaS products.
This analysis shows why Domino’s and Adobe trade at similar multiples despite different growth rates. By looking at ROIC, we see how much capital these companies need to create returns and how much can be returned to shareholders.
While P/E still depends on many other variables (and this doesn’t explain everything), evaluating ROIC is important for understanding a company’s capital efficiency. ROIC moves us beyond the simplistic view that high P/E means high growth and low P/E means low growth. Instead, it reveals that investing in public companies is fundamentally about the returns generated for shareholders.
source: S&P Capital IQ
source: FactSet