1-Re investment Rate

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darshanP

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I have been reading Ashwath Damodaran’s Little book of Valuation…i have been trying to forecast the company…while reading the book I have come across thie formula which he used and CFA L2 doesn’t, is FCFF=After tax operating income(1- Re investment Rate).
Ok i know what is Re investment rate, its=(Net CapEx+Changes in Workin Cap)/after tax operating Income. But whay 1-Re investment Rate what does 1- Reinvestment stand for and why did he multiply it.
In L 2 i have learned that Termminal year cahflow will be multiplied with perpatual G…but in this book he has multiplied Terminal Year casflow with 1-reinvestment rate too…why?
And i would be indebted if somebody can guide me on how to do Forecasting and Valuation and other books that teache me step by step forecasting.
Tanks
 
Hi,
you multiply the after tax operating income (NOPAT) with 1 minus the re-investing rate because the delta of the reinvestment rate and 100% will be exactly the percentage of NOPAT left over after investing CAPEX and NWC and adding back the depreciation. And this will be the operating Free-Cash Flow to Entity which is used in the DCF world to compute the Enterprise Value.
Regarding literature on valuation I’d recommend you the book “Valuation” from Koller, Goedhart and Wessels which is one of the standard books. There are however plenty of other books on this topic depending on how deep you want to dig into the topic.
Best,
Oscar
 
Because the free cash flow to firm is the after tax cash available for use after paying out all expenses nessecary to keep the business running. So we also subtract from the NOPAT the percentage required to do so. You should also add back depreciation, since it is a non-cash expense included in the calculation of NOPAT.
This gives you FCF = NOPAT * (1-ReInv), with (1-ReInv) being another term for retention rate. which is similar to the retention rate on dividend payout ratios.
Terminal, or continuing value is a function of a perpetutiy assumption. So you multiply this year’s cash flow by the sustainable rate of growth (giving you CF for t=1 in the numerator) and dividing that by the required rate of return minus the sustainable growth rate.
In this instance, you could achieve the same results using the retention rate instead. I’ll show you why.
FCF = NOPAT - Net Investment
ReInv rate (%) = Net Investment / NOPAT
Therefore FCF = NOPAT * (1-ReInv) (1)
Similary, growth of cash (g) = RONIC * ReInv (2)
This means that a company grows it’s FCF by the proportion of reinvested cash on it’s return on newly invested capital. So if I make 25% on every dollar I invest, and I put back 80% of what I earn to reinvest, then I am growing my company by 0.25c * 80% = 0.20c every year.
ReInv can also be equal to ReInv = g / RONIC (3) based on the above.
Therefore from (1) and (3), FCF = NOPAT ( 1 - g / RONIC)
Now that we established that perpetuity = FCF at t1 / WACC - g, we can rebuild the perpetuity formula to include NOPAT instead as the value driver.
Which gives us V = NOPAT (1 - g / RONIC) divided by WACC - g
In other words, he has substituted the plain perpeturity forumla using only g as the value driver with another important value driver. Since growing faster than you earn a return will give you a lower continuing value, something you can’t derive from g alone, in addition to making an assumption of future returns on invested capital for the explicit period of the forecast, which is generally lower than earlier years, and in many cases, equal to WACC.
The book on Valuation by Koller, Damodaran’s Investment Valuation, Rosenbaum’s Investment Banking should be all good. I’d also recommend the Investment Checklist as the best book on performing proper research on companies to invest in,
 
Thanks Oscar…i understood the same way..but was in dilemma…thanks for clarifying.
and Good luck for Today’s match…tough i’m belong to India and dont have mcuh football fever but…i am supporting Germany…Good luck..
 
@MrSmart …wow….that was indeed very informative and deep…i wish i could explain like you…but yeah i was aware of all the concepts you have mentioned but didnt put it altogather..thanks bro
and thanks for the list of books…i will look into it once i will done with current book…Thanks
 
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