A company trades at 20 times forward free cash flow with a 9% cost of capital. What perpetual growth rate does the multiple imply? If margins are expected to rise from 12% to 15% over three years, what growth does the same price imply on normalised cash flow?

A company trades at 20 times forward free cash flow with a 9% cost of capital. What perpetual growth rate does the multiple imply? If margins are expected to rise from 12% to 15% over three years, what growth does the same price imply on normalised cash flow?

Approach: Invert the Gordon growth relation to read growth out of a multiple, then rerun it on the cash flow the business will earn once the margin expansion has already happened.

4%. The Gordon growth relation gives multiple = 1/(r - g), so 20 = 1/(0.09 - g) and the implied growth is 0.09 - 0.05, which is 4%. If margins rise from 12% to 15%, normalised free cash flow is 15/12, or 1.25 times the current level, so the same price is 20/1.25, which is 16 times normalised cash flow, and the implied growth falls to 0.09 - 1/16, which is 2.75%. The gap between the two figures is the discipline in the exercise: a forward multiple prices growth and margin expansion together, so paying 20 times for a business whose margin is about to rise by a quarter is really paying 16 times for 2.75% growth. Reading the multiple without normalising the denominator credits the same improvement twice.

Follow-up: The company also needs capital expenditure equal to 40% of the incremental cash flow to hold that growth. What does the implied growth become?

Key concepts: Gordon growth, implied growth, forward multiple, margin expansion.