You may assume that a faster-growing business always deserves a premium valuation but that’s not always the case. Growth is not the only criterion that determines valuation. The cost of growth matters just as much.

In this article, I will explore four things:

(I) Why growth is not the only factor that determines value
(II) Why companies with high returns on retained capital deserve a higher valuation
(III) How much we should pay for a business by looking at its reinvestment opportunities and returns on retained capital
(IV) Two real-life companies that have generated tremendous returns for shareholders based on high returns on retained capital

Growth is not the only factor

To explain why returns on retained capital matter, let’s examine a simple example.

Companies A and B both earn $1 per share in the upcoming year. Company A doesn’t reinvest its earnings. Instead, it gives its profits back to shareholders in the form of dividends. Company B, on the other hand, is able to reinvest all of its profits back into its business for an 8% return each year. The table below illustrates the earnings per share of the two companies over the next 5 years:

Company B is clearly growing its earnings per share much quicker than Company A. But that does not mean we should pay a premium valuation. We need to remember that Company B does not pay a dividend, whereas Company A pays $1 per share in dividends each year. Shareholders can reinvest that dividend to generate additional returns.

Let’s assume that an investor can make 10% a year from reinvesting the dividend collected from Company A. Here is how much the investor “earns” from being a shareholder of Company A compared to Company B after reinvesting the dividends earned each year:

The table just above shows that investors can earn more from investing in Company A and reinvesting the dividends than from investing in Company B. Company B’s return on retained capital is lower than the return we can get from reinvesting our dividends. In this case, we should pay less for Company B than Company A.

Retaining earnings to grow a company can be a powerful tool. But using that retained earnings effectively is what drives real value to the shareholder.

High-return companies

Conversely, investors should pay a premium for a company that generates a higher return on retained capital. Let’s look at another example.

Companies C and D both will generate $1 per share in earnings this year. Company C reinvests all of its earnings to generate a 10% return on retained capital. Company D, on the other hand, is able to generate a 20% return on retained capital. However, Company D only reinvests 50% of its profits and returns the rest to shareholders as dividends. The table below shows the earnings per share of both companies in the next 5 years:

As you may have figured, both companies are growing at exactly the same rate. This is because while Company D is generating double the returns on retained capital, it only reinvests 50% of its profit. The other 50% is returned to shareholders as dividends.

But don’t forget that investors can reinvest Company D’s dividends for more returns. The table below shows what shareholders can “earn” if they are able to generate 10% returns on reinvested dividends:

So while Companies C and D are growing at exactly the same rates, investors should be willing to pay a premium for Company D because it is generating higher returns on retained capital.

How much of a premium should we pay?

What the above examples show is that growth is not the only thing that matters. The cost of that growth matters more. Investors should be willing to pay a premium for a company that is able to generate high returns on retained capital.

But how much of a premium should an investor be willing to pay? We can calculate that premium using a discounted cash flow (DCF) model.

Let’s use Companies A, B, C, and D as examples again. But this time, let’s also add Company E into the mix. Company E reinvests 100% of its earnings at a 20% return on retained capital. The table below shows the earnings per share to each company’s shareholders, with dividends reinvested:

Let’s assume that the reinvestment opportunity for each company lasts for 10 years before it is exhausted. All the companies above then start returning 100% of their earnings back to shareholders each year. From then on, earnings remain flat. As the dividend reinvestment opportunity above is 10%, we should use a 10% discount rate to calculate how much an investor should pay for each company. The table below shows the price per share and price-to-earnings (P/E) multiples that one can pay:

We can see that companies with higher returns on retained capital invested deserve a higher P/E multiple. In addition, if a company has the potential to redeploy more of its earnings at high rates of return, it deserves an even higher valuation. This is why Company E deserves a higher multiple than Company D even though both deploy their retained capital at similar rates of return.

If a company is generating relatively low returns on capital, it is better for the company to return cash to shareholders in the form of dividends as shareholders can generate more returns from redeploying that cash elsewhere. This is why Company B deserves the lowest valuation. In this case, poor capital allocation decisions by the management team are destroying shareholder returns even though the company is growing. This is because the return on retained capital is below the “hurdle rate” of 10%.

Real-life example #1

Let’s look at two real-life examples. Both companies are exceptional businesses that have generated exceptional returns for shareholders.

The first company is Constellation Software Inc (TSE: CSU), a holding company that acquires vertical market software (VMS) businesses to grow. Constellation has a remarkable track record of acquiring VMS businesses at very low valuations, thus enabling it to generate double-digit returns on incremental capital invested.

From 2011 to 2021, Constellation generated a total of US$5.8 billion in free cash flow. It was able to redeploy US$4.1 billion of that free cash flow to acquire new businesses and it paid out US$1.3 billion in dividends. Over that time, the annual free cash flow of the company grew steadily and materially from US$146 million in 2011 to US$1.2 billion in 2021.

In other words, Constellation retained around 78% of its free cash flow and returned 22% of it to shareholders. The 78% of free cash flow retained was able to drive a 23% annualised growth in free cash flow. The return on retained capital was a whopping 30% per year (23/78). It is, hence, not surprising to see that Constellation’s stock price is up by around 33 times since 2011.

Today, Constellation sports a market cap of around US$37 billion and generated around US$1.3 billion in free cash flow on a trailing basis after accounting for one-off working capital headwinds. This translates to around 38 times its trailing free cash flow. Is that expensive?

Let’s assume that Constellation can continue to reinvest/retain the same amount of free cash flow at similar rates of return for the next 10 years before reinvestment opportunities dry out. In this scenario, we can pay around 34 times its free cash flow to generate a 10% annualised return. Given these assumptions, Constellation may be slightly expensive for an investor who wishes to earn an annual return of at least 10%. 

Real-life example #2

Simulations Plus (NASDAQ: SLP) is a company that provides modelling and simulation software for drug discovery and development. From FY2011 to FY2022 (its financial year ends in August), Simulations Plus generated a total of US$100 million in free cash flow. It paid out US$47 million in dividends during that time, retaining 53% of its free cash flow.

In that time period, Simulations Plus’s free cash flow per share also grew from US$0.15 in FY2011 to US$0.82 in FY2022. This translates to 14% annualised growth while retaining/reinvesting just 53% of its free cash flow. The company’s return on retained capital was thus 26%.

Simulations Plus’s stock price has skyrocketed from US$3 at the end of 2011 to US$42 today. At the current price, the company trades at around 47 times trailing free cash flow per share. Is this expensive?

Since Simulations Plus is still a small company in a fragmented but growing industry, its reinvestment opportunity can potentially last 20 years. Let’s assume that it maintains a return on retained capital of 26% and we can reinvest our dividends at a 10% rate of return. After 20 years, the company’s reinvestment opportunity dries up. In this scenario, we should be willing to pay around 44 times its annual free cash flow for the business. Again, today’s share price may be slightly expensive if we want to achieve a 10% rate of return.

The bottom line

Investors often assume that we should pay up for a faster-growing business. However, the cost of growth matters. When looking at a business, we need to analyse the company’s growth profile and its cost of growth.

The reinvestment opportunity matters too. If a company has a high return on retained capital but only retains a small per cent of annual profits to reinvest, then growth will be slow.

Thirdly, the duration of the reinvestment opportunity needs to be taken into account too. A company that can redeploy 100% of its earnings at high rates of returns for 20 years deserves a higher multiple than one that can only redeploy that earnings over 10 years.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I do not have a vested interest in any stocks mentioned. Holdings are subject to change at any time.