Topic 55

Growth, C*, and Return: The Engine to Increased Valuations and Deferred Tax Advantage

Topic 55 explores the significance of the interdependency between growth return on operating capital and the weighted average cost of capital, C*. Growth is the engine to increased entity valuation and higher valuation multiples (see Topics 20, 57, and 59).

INTERDEPENDENCIES AMONG GROWTH, RATE OF RETURN, AND COST OF CAPITAL

  • The interdependencies among growth during the T period years, (gT), rate of return on operating capital employed (r) (equal to operating profit after tax [NOPAT])/net operating capital) and cost of capital (C*) and the impacts on business results and valuation drivers are presented in Appendix 55.1 and briefly summarized here.
    • The greater the positive spread between r and C*, the greater the firm's valuation and valuation multiples.
    • To the extent gT is equal to r (assuming investment requirements over the long term essentially equal depreciation), annual growth in valuation will approximate gT, external financing requirements will be minimized, and cash requirements for growth are met by cash generation.
    • To the extent that gT is less than r, growth in valuation period to period will approximate gT, and excess cash will accumulate in the business simply increasing value period to period by the increase in the amount of cash.
    • However, if gT exceeds r, growth in enterprise valuation and gT eventually will settle to a rate to approximate the sustainable growth rate, ...

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