Case 067Relative valuationCore

Sorvani Tech trades at 25x earnings with 14% growth and a 35% ROIC; Delkora Systems at 18x with 7% growth and a 25% ROIC. Which is cheaper once growth and returns are both counted?

The situation

Two IT services companies. Sorvani Tech trades at 25x this year's earnings, expects earnings growth of 14% a year, and earns a 35% return on invested capital, ROIC. Delkora Systems trades at 18x, expects 7% growth and earns a 25% ROIC.

Use an 11% cost of equity for both. Assume each grows at its stated rate for ten years and then at 5% forever, and that each reinvests just enough of its earnings to fund its growth at its ROIC, paying out the rest.

Your task

Compute a justified P/E for each from growth and ROIC, compare it with the market's P/E, and say which is cheaper and why the headline P/E misleads.

Quick check

Which stock is cheaper relative to what its growth and returns justify?

Worked solution

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

30-second answerThe answer to give first

Sorvani is cheaper: it trades at 25x against a justified 26.6x, about 6% below, while Delkora trades at 18x against a justified 15.6x, about 15% above. Growth is worth more when return on capital is higher, because less of each year's profit has to be reinvested to produce it. Comparing 25x with 18x ignores both.

Step 1Why is growth worth more at a higher return on capital?

Two shopkeepers each want to grow sales 10%. One needs Rs 1 of new stock for every Rs 3 of extra profit; the other needs Rs 1 for every Rs 2. The first keeps more of his profit to take home. Growth is paid for by reinvestment, and the share of profit that must be reinvested is growth divided by return on capital, so a higher ROIC buys the same growth with less of the profit. Sorvani reinvests 14/35, 40% of earnings, and pays out 60%. Delkora reinvests 7/25, 28%, and pays out 72%.

The relationship
payout=1−gROICPE=∑t=110(1+g)t(1−g/ROIC)(1+k)t+TV10(1+k)10\text{payout} = 1 - \frac{g}{ROIC} \qquad \frac{P}{E} = \sum_{t=1}^{10} \frac{(1+g)^t (1 - g/ROIC)}{(1+k)^t} + \frac{TV_{10}}{(1+k)^{10}}
gearnings growth a year for ten years
ROICreturn earned on each rupee reinvested
kcost of equity, 11%
TV_10value at year 10 of the 5% growth phase, with payout 1 - 5%/ROIC
What it says in wordsA justified P/E is the present value of the cash each rupee of earnings can pay out, which depends on both growth and how much reinvestment that growth needs.
Step 2What P/E does each deserve?

Run the formula for each. Sorvani's 14% growth at 35% ROIC justifies about 26.6x; Delkora's 7% at 25% justifies about 15.6x. The market has them the other way round relative to value: Sorvani at 0.94 of justified, Delkora at 1.15. The PEG ratio points the same way, 1.79 against 2.57, but only by accident: PEG ignores ROIC and would mislead for two companies with equal growth and different returns.

Justified P/E by growth: higher ROIC makes growth worth more10x15x20x25x30xROIC 35%ROIC 25%Sorvani: trades 25x, justified 26.6xDelkora: trades 18x, justified 15.6xopen circle = justified P/E0%4%8%12%16%Earnings growth a year for ten years, then 5%
At an 11% cost of equity, the justified P/E curve for a 35% ROIC rises more steeply with growth than the curve for 25%, and Sorvani at 25x sits below its justified 26.6x while Delkora at 18x sits above its justified 15.6x.
Market P/EGrowthROICPayoutJustified P/EMarket / justified
Sorvani Tech25x14%35%60%26.6x0.94
Delkora Systems18x7%25%72%15.6x1.15
Sorvani trades at 0.94 times its justified P/E of 26.6x and Delkora at 1.15 times its justified 15.6x, so the stock with the higher headline multiple is the cheaper one.
Step 3How sensitive is the answer, and what would reverse it?

Two checks. Cut Sorvani's ROIC to 25% and its justified P/E falls to about 23.4x, below 25x, so the conclusion rests on Sorvani sustaining high returns as it grows. The call is only as good as the ROIC assumption, so ask whether Sorvani's returns are rising or being competed away. And the cost of equity moves both answers: at 12% Sorvani's justified P/E falls to about 22.0x. Say that the ranking holds across sensible discount rates while the levels do not.

Where candidates lose it

The instinctive answer is that 18x is cheaper than 25x. It compares two numbers that price different businesses and is the exact habit the question is designed to catch.

The second loss is reaching for PEG and stopping. PEG treats all growth as equal; the interviewer wants to hear that growth funded at a 35% return is worth more than growth funded at 25%.

What the interviewer asks next

  • At what growth rate would Delkora's justified P/E equal 18x?
  • Why does growth add nothing to value when ROIC equals the cost of equity?
  • How would you estimate ROIC for an IT services company that capitalises little?

Company names and figures are illustrative.