Case 099Long pitches and valuationHard

Varuni Retail earns a 25% ROIC, reinvests 60% of earnings and trades at 40x. Ostrel Metals earns an 8% ROIC, pays out everything and trades at 8x. Over ten years both multiples converge to 15x. Which stock returns more, and how sensitive is the answer to the exit multiple?

Coatue ManagementNew York · 2023

The situation

Varuni Retail earns a 25% return on invested capital and reinvests 60% of its earnings at that rate, paying the rest as dividends. It trades at 40x earnings. Ostrel Metals earns an 8% return on capital, reinvests nothing, pays out all its earnings and trades at 8x.

Assume both keep their returns for ten years, and that by year ten both trade at 15x, because the market stops paying a premium for Varuni and stops pricing Ostrel as a melting ice cube. Dividends are received at the end of each year.

Your task

Which stock returns more over ten years, why, and how sensitive is the answer to the exit multiple?

Quick check

Before any maths: over ten years with both ending at 15x, which returns more?

Worked solution

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

30-second answerThe answer to give first

Ostrel returns about 16.5% a year against about 6.1% for Varuni, because the multiple change swamps the quality gap over ten years. Varuni grows earnings 15% a year, 25% ROIC times 60% reinvested, but falling from 40x to 15x costs it about 9% a year. Ostrel collects a 12.5% yield and its multiple nearly doubles. Varuni needs to hold roughly 40x to catch up, so the answer depends on the exit multiple more than on quality.

Step 1Where does each stock's return come from?

Three engines: earnings growth, dividends and the change in multiple. Think of buying a mango orchard. One orchard is young and planting new trees every year but costs forty years of harvest; the other is old, grows nothing new, and costs eight years of harvest. Varuni's earnings grow at ROIC times reinvestment, 25% x 60%, which is 15% a year, with a dividend yield of just 1%; Ostrel's earnings do not grow, but it pays 12.5% a year. Then the multiples move: Varuni's from 40x to 15x, Ostrel's from 8x to 15x.

The relationship
g=ROIC×b=25%×60%=15%(1540)1/10−1≈−9.3% a yearg = \text{ROIC} \times b = 25\% \times 60\% = 15\% \qquad \left(\frac{15}{40}\right)^{1/10} - 1 \approx -9.3\% \text{ a year}
ROICreturn earned on reinvested capital
bshare of earnings reinvested
15/40Varuni's exit multiple over its entry multiple
What it says in wordsGrowth comes from reinvesting at the business's return, and a falling multiple takes away a steady share of it every year.
Step 2What does Rs 100 in each become?

Follow the money. Rs 100 of Varuni buys Rs 2.50 of earnings, which grow to about Rs 10.11 by year ten; at 15x that is Rs 152, plus about Rs 23 of dividends along the way. Rs 100 of Ostrel buys Rs 12.50 of earnings that never grow; at 15x that is Rs 188, plus Rs 125 of dividends. As yearly returns, Ostrel earns about 16.5% and Varuni about 6.1%.

Rs 100 in each, price plus dividends received, both converging to 15x100200300Ostrel: 312, 16.5% a yearVaruni: 175, 6.1% a yearOstrel: 8x to 15x, 12.5% yield, no growthVaruni: 40x to 15x, 15% growth, 1% yield0246810Years (Rs, price plus dividends received, on the vertical axis)
With both multiples converging to 15x, Rs 100 in Ostrel becomes Rs 188 of shares plus Rs 125 of dividends, about 16.5% a year, while Rs 100 in Varuni becomes Rs 152 plus about Rs 23, about 6.1% a year.
Step 3How sensitive is the answer to the exit multiple?

Very. Every five turns of exit multiple adds roughly two to three points a year to Varuni:15x gives 6.1%, 20x gives 8.9%, 25x gives 11.1%, 30x gives 13.0%, 40x gives 16.1%. Only if the market still pays about 40x in year ten does Varuni match Ostrel's 16.5%. Ostrel is less sensitive: even with no re-rating, staying at 8x, it returns 12.5%, its dividend yield. That asymmetry is the heart of the interviewer's question.

Ten-year return, % a year, against the exit multipleVaruni Retailexit 15x6.1%exit 20x8.9%exit 25x11.1%exit 30x13.0%exit 40x16.1%Ostrel Metalsexit 8x12.5%exit 10x13.8%exit 15x16.5%
Varuni's ten-year return ranges from 6.1% at a 15x exit to 16.1% at 40x, while Ostrel's ranges from 12.5% with no re-rating to 16.5% at 15x, so Varuni needs to keep about 40x to catch up.
Step 4So would you rather own quality at an ok price or a poor business at a great price?

Answer with the conditions, not a slogan. Over ten years, price wins here, because 40x is not an ok price: it already assumes decades of 15% growth. Stretch the horizon and quality catches up; on these assumptions Varuni overtakes only after about 29 years, since compounding at 25% on retained capital eventually beats any one-off re-rating. The weak point in the Ostrel case is the flat-earnings assumption: an 8% ROIC metals business is cyclical, and a bad cycle can cut the dividend just when you are counting on it. The honest answer names the horizon and the risk you are taking on each side.

Where candidates lose it

The common miss is picking Varuni because 25% ROIC and 15% growth sound superior, without pricing the fall from 40x to 15x. Quality is only a good investment at a price that has not already paid for it.

The second is the reverse: treating Ostrel's 12.5% yield as safe. The low multiple partly reflects the risk that flat earnings are a best case in a cyclical industry.

What the interviewer asks next

  • At what entry multiple would Varuni match Ostrel over ten years with a 15x exit?
  • Ostrel's earnings fall 30% in year four and recover in year six. What happens to its return?
  • How would you pair the two stocks in a long-short book, and what factor bet would the pair carry?

Asked at Coatue Management, Technology, Media and Telecom (TMT), New York, 2023 (Wall Street Oasis): Would you rather buy a low quality business at a great price or a high quality business at an ok price?

Company names and figures are illustrative.