How to Calculate the Estimated Growth Rate in Operating Income for Disney (Stable Margins and ROC case)

How to Calculate the Estimated Growth Rate in Operating Income for Disney (Stable Margins and ROC case)

The dividend discount and FCFE models are models for valuing the equity in a firm directly. The alternative is to value the entire business and then to use this value to arrive at a value for the equity. That is precisely what we try and do in firm valuation models, where we focus on the operating assets of a firm and the cash flows they generate.

1.    Let’s set up the model:

The cash flow to the firm can be measured in two ways:
1) to add up the cash flows to all of the different claim holders in the firm. Thus, the cash flows to equity investors (which take the form of dividends or stock buybacks) are added to the cash flows to debt holders (interest and net debt payments) to arrive at the cash flow to the firm.

2) the other approach to estimating cash flow to the firm, which should yield equivalent results, is to estimate the cash flows to the firm prior to debt payments but after reinvestment needs have been met:

EBIT(1- tax rate)- (Capex – Depreciation) – Change in noncash working capital = free cash flow to the firm

The difference between capital expenditures and depreciation (net capital expenditures) and the increase in noncash working capital represent the reinvestment made by the firm to generate future growth.

Another way of presenting the same equation is to add the net capital expenditures and the change in working capital and state that value as a percentage of the after-tax operating income. This ratio of reinvestment to after-tax operating income is called reinvestment rate, and the FCFF can be written as:
FCFF= EBIT(1-t)(1-Reinvestment rate)

Note that the reinvestment rate can exceed 100% if the firm has substantial reinvestment needs. If that occurs, the FCFF will be negative, even though after-tax operating income is positive.

This cash flow to the firm is often called “unlevered cash flow”, because it is unaffected by debt payments or the tax benefits flowing from these payments.

As with the dividends and the FCFE, the value of the operating assets of a firm can be written as the present value of the expected cash flows during the high-growth period and a terminal value at the end of the period:
Value= expected cash flows during high-growth period + terminal value at the end of the period.

2.    Estimating the model inputs

As with the DDM and FCFE models, there are 4 basic components that go into the value of the operating assets of the firm-
a. a period of high growth
b. the FCFF during that period

c. the cost of capital to use as a discount rate

d. the terminal value for the operating assets of the firm.

We have additional steps to take to get to the value of equity per share. In particular, we have to incorporate the value of nonoperating assets, subtract out debt, and then consider the effect of options outstanding and other claims on the equity of the firm.

Estimating FCFF during High-Growth Period
We based our estimate of a firm’s value on expected future cash flows, not on current cash flows. The forecasts of earnings, net capital expenditures, and working capital will yield these expected cash flows. To estimate free cash flows to the firm during the high-growth period, the key building blocks are the expected operating income after taxes each year and the reinvestment rate that the firm has to make to get its future growth. In this section, we will look at two scenarios, one where you expect the operating margins and return on capital to stay stable over the high-growth period and a more general one, where margins and returns on capital can change over time.

1.    Stable margins and return on capital

If a firm is expected to maintain its current return on capital, as with the growth rates we estimated for dividends and net income, the variables that determine expected growth are simple. The expected growth in operating income is a product of a firm’s reinvestment rate, i.e., the proportion of the after-tax operating income that is invested in net capital expenditures and noncash working capital, and the quality of these reinvestments, measured as the after-tax return on the capital invested.

Expected growth = Reinvestment rate * Return on Capital

Reinvestment rate= Capital expenditures – Depreciation + change in noncash WC/
                   EBIT(1- Tax rate)

Return on Capital=  EBIT(1-t)/ (BV of equity + BV of debt – Cash)

Both measures should be forward-looking, and the return on capital should represent the expected return on capital on future investments. In the rest of this section, we consider how best to estimate the reinvestment rate and the return on capital.

Reinvestment rate

The reinvestment rate is often measured using a firm’s past history on reinvestment. Although this is a good place to start, it is not necessarily the best estimate of the future reinvestment rate.
A firm’s reinvestment rate can ebb and flow, especially in firms that invest in relatively few large projects or acquisitions. For these firms, looking at an average reinvestment rate over time may be a better measure of the future. In addition, as firms grow and mature, their reinvestment needs and rates tend to decrease. For firms that have expanded significantly over the past few years, the historical reinvestment rate is likely to be higher than the expected future reinvestment rate. For these firms, industry averages for reinvestment rates may provide a better indication of the future than using numbers from the past.

Finally, it is important that we continue treating R&D expenses and operating lease expenses consistently. The R&D expenses in particular need to be categorized as part of capital expenditures for purposes of measuring the reinvestment rate.

Return on Capital

The return on capital is often based on the firm’s return on capital on existing investments, where the book value of capital is assumed to measure the capital invested in these investments. Implicitly, we assume that the current accounting return on capital is a good measure of the true returns earned on existing investments and that this return is a good proxy for returns that will be made on future investments. This assumption, of course, is open to question when the book value of capital is not a good measure of the capital invested in existing projects and when the operating income is mismeasured or volatile. Given these concerns, we should consider not only a firm’s current return on capital but also any trends in this return as well as the industry average return on capital. If the current return on capital for a firm is significantly higher than the industry average, the forecasted return on capital should be set lower than the current return to reflect the erosion that is likely to occur as competition responds.

Finally, any firm that earns a return on capital greater than its cost of capital is earning an excess return. These excess returns are the result of a firm’s competitive advantages or barriers to entry into the industry. High excess returns locked in for very long periods imply that a firm has a permanent competitive advantage.

Estimating Growth Rate in Operating Income for Disney
We begin by estimating the reinvestment rate and return on capital for Disney in 2013 using the numbers from the latest financial statements. We converted operating leases into debt and adjusted the operating income and capital expenditures accordingly.

Reinvestment rate= (Capital expenditure – depreciation + Change in WC)/ EBIT(1-T)
= (6114-2845+103)/ (10032(1-0.3102)) = 53.93%

We compute the return on capital, using operating income in 2013 and capital invested at the start of the year:
Return on capital = EBIT(1-t)/ (BV of equity +BV of debt – Cash)
= 10032(1-0.312)/(41,958+16328-3387)= 12.61%

If Disney maintains its 2013 reinvestment rate and return on capital for the next few years, its growth rate will be 6.80%
Expected growth rate from existing fundamentals = 53.93% * 12.61% =6.80%

 Note that assuing that Disney’s return on capital and reinvestment for the next five years will resemble the average over the last five years, instead of the 2013 values, would result in a different expected growth rate (and value for Disney).