Case 017Relative valuationCore

Compare two sectors through one company each: Medrova Hospitals grows 15% with an 18% return on capital at 55x earnings; Ghatola Cement grows 8% with a 12% return on capital at 30x. Which offers better prospects for the price?

Wellington ManagementHong Kong · 2022

The situation

You covered hospitals and cement in your internships and the interviewer asks which sector has better prospects. Use one representative company for each. Medrova Hospitals: earnings growth of 15% a year expected for the next decade, return on capital employed 18%, P/E 55x. Ghatola Cement: earnings growth of 8% a year, return on capital 12%, P/E 30x.

Assume each company reinvests just enough to fund its growth at its return on capital and pays out the rest, and that after ten years both grow 6% a year. Take 25x as the market's multiple for a company that will then earn a 15% return on capital.

Your task

Compare the two on what you get for the price, not only on growth, and give a view with the assumption it rests on.

Quick check

Medrova's PEG is 3.67 and Ghatola's is 3.75. What does that tell you?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Medrova offers the better prospects for its price, but only because its growth earns well above the cost of capital; the margin depends on that return lasting. PEG calls it a tie. On ten years of growth plus a cash yield, Medrova returns about 7.7% a year against 5.2% for Ghatola once exit multiples reflect return on capital. If every stock exits at the same 25x, Ghatola edges ahead, 7.2% against 6.6%.

Step 1Why is growth alone the wrong comparison?

Two shops both grow sales 10% a year. One needs a new branch for every rupee of extra profit; the other just adds a shelf. Same growth, very different cash left for the owner. What growth is worth depends on the return earned on the capital it needs, so compare growth, return on capital and price together. Medrova must reinvest 83% of profit to grow 15% at 18%; Ghatola must reinvest 67% to grow 8% at 12%. Ghatola's 12% return is barely above a typical cost of equity, so its growth adds little value per rupee reinvested.

Same questions of both sectors: what do you get for what you pay?Medrova HospitalsEarnings growth15%Return on capital18%P/E55xPEG3.67Free cash flow yield0.3%Expected return a year, ten years:all exit at 25x6.6%exit at 28x, set by return on capital7.7%Price lags prospectsGhatola CementEarnings growth8%Return on capital12%P/E30xPEG3.75Free cash flow yield1.1%Expected return a year, ten years:all exit at 25x7.2%exit at 21x, set by return on capital5.2%Price already ahead of prospects
Medrova and Ghatola have almost the same PEG, 3.67 and 3.75, but Medrova's growth earns 18% on capital against Ghatola's 12%; with exit multiples set by return on capital, Medrova's expected return is about 7.7% a year against 5.2% for Ghatola.
Step 2How do you turn this into an expected return?

Ask what an investor collects over ten years: the free cash yield today, plus earnings growth, adjusted for how the multiple changes by year ten. The exit multiple is the assumption that decides the answer, so state it and test it. If both stocks drift to the same 25x, Medrova's multiple falls by more than half and its return is about 6.6% a year against Ghatola's 7.2%. But a business still earning 18% on capital deserves a higher multiple than one earning 12%. Scaling the exit multiple by how much of its profit each can pay out at 6% growth gives Medrova about 28x and Ghatola 21x, and the returns become 7.7% and 5.2%.

Medrova HospitalsGhatola Cement
Earnings after 10 years, times today4.05x2.16x
Free cash flow yield today0.3%1.1%
Return a year, all exit at 25x6.6%7.2%
Exit multiple set by return on capital27.8x20.8x
Return a year, adjusted exit7.7%5.2%
Medrova's earnings grow 4.0 times in ten years against Ghatola's 2.2 times; with exit multiples tied to return on capital, that gives about 7.7% a year for Medrova and 5.2% for Ghatola.
Step 3What would change the view?

Medrova's case rests on fifteen per cent growth for a full decade at an eighteen per cent return. If growth fades to 10% after five years, most of its advantage goes, so the research job is the bed pipeline, occupancy in new hospitals and whether new hospitals reach the returns of old ones. For Ghatola, the question is whether consolidation can lift the return on capital; a cement company earning 15% would deserve a very different multiple. Say which of those you would check first, and why.

Where candidates lose it

The weak answer compares P/E ratios, calls cement cheap at 30x against hospitals at 55x, and stops. Or it divides by growth, finds a tie, and has nothing more to say.

The strong answer brings in return on capital, because it decides how much of today's profit must be ploughed back to deliver the growth, and then names the exit multiple as the assumption that swings the conclusion.

What the interviewer asks next

  • At what return on capital would Ghatola's 8% growth add no value at all?
  • How would rising interest rates affect the two multiples differently?
  • Which sector would you rather own through a recession, and why?

Asked at Wellington Management, Generalist, Hong Kong, 2022 (Wall Street Oasis): How would you compared the sectors you covered in previous internships and which one you think has the most prospects?

Company names and figures are illustrative.