Last month, we analyzed whether the premium valuations of multinational company subsidiaries (MNCs) in India relative to their overseas parent companies is attributable to a superior growth profile or other factors like excess domestic liquidity.
Our method? Compare the valuations of the MNC parents and MNC subsidiaries from a decade ago to their subsequent cash flows.
Our conclusion? That the superior growth profile of MNC subsidiaries explained much of the 75% premium multiples they traded at in December 2008.
Here we will examine the current valuations of these two sets of companies and calculate the implied future growth in cash flows that the current valuations are pricing in.
The valuations of MNC subsidiaries have done very well in the 2009 to 2020 period, growing more than six-fold. On 30 June 2020, the set of Indian MNC subsidiaries in our sample had achieved an enterprise value (EV) of US $167 billion. The MNC subsidiaries have risen at a CAGR of over 17% from their EV of $27 billion on 31 December 2008.
By contrast, the EV of MNC parents on 30 June 2020 was US $3,114 billion, and had increased at a more modest CAGR of 5.7% from their EV of US $1,634 billion on 31 December 2008.
The question is: Are investors correctly pricing expected future growth in the current valuations?
To answer that, we calculated the differential growth rates in free cash flows required for Indian MNC subsidiaries to justify their higher valuations relative to their parents. We assumed that the growth outperformance of MNC subsidiaries will continue for the next 15 years and then disappear, at which point MNC subsidiaries will grow at the same rate as their parents. In the parlance of the discounted cash flow (DCF) model, the first 15 years constitute the explicit forecast period and are followed by a perpetuity / terminal year.
Further, we calculated that the real weighted-average cost of capital (WACC) for each MNC subsidiary as the same as its parent. Since the subsidiaries’ cash flows are in Indian rupees (INR), we determined their WACCs in INR by adding a premium of 3.5% to the WACCs of their parents to reflect the inflation differential between India and the developed economies. Similarly, we anticipated a perpetuity growth rate of 1% for MNC parents and 4.5% for their subsidiaries.
Our starting point for calculating the companies’ future cash flows is the actual cash flows they earned in the year ending 31 December 2019 / 31 March 2020. When the current year cash flows are abnormal — either well above or well below historical cash flows due to one-off factors — we computed and applied an average of historical 10-year cash margins (free cash flow to the firm (FCFF)/net sales) on the last financial year’s net sales to calculate a normalized cash flow, which we then used to extrapolate the cash flows for the next 15 years.
As of 30 June 2020, the MNC parents traded at an EV/EBITDA multiple of 10x compared to 8.5x on 31 December 2008. The MNC subsidiaries were valued at an EV/EBITDA multiple of 29.4x, a sharp increase from 14.8x on 31 December 2008.
To justify their elevated valuation, MNC subsidiaries have to grow their free cash flows at a cumulative average rate of 13.1% for the next 15 years. Their MNC parents only need a 2.2% CAGR over the same period. Thus, the MNC subsidiaries must attain a differential growth rate of 11% p.a. for the next 15 years.
Since the Indian economy should (optimistically) achieve a long-term growth rate of about 6% to 8% per year and assuming a 3.5% inflation differential between India and the developed economies, that 11% growth is possible if somewhat ambitious.
Of course, this is growth in free cash flows, not in profits. Investment in capital assets and net working capital are netted off from cash profits to calculate free cash flows. Double-digit profit growth would require a commensurate turnover increase, as the scope for margin expansions may be limited. This would require high capex and working capital investment.
On the other hand, the reduction in India’s marginal corporate tax rate from about 34.6% to 25.2% in August 2019 should help generate higher free cash flows since most MNC subsidiaries paid the highest effective tax rate.
In the March 2009 to March 2020 period, the free cash flows of MNC subsidiaries grew at a CAGR of about 8%. Admittedly, the 2010s — described by various commentators as “India’s Lost Decade” — has not been a great era for corporate profitability growth.
We can only hope that the future will be better and that the MNC subsidiaries justify their growth premium.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images / Ashwin Nagpal
Navin Vohra, CFA, heads the Valuations, Modelling and Economics practice of Ernst & Young India. He has 25 years of experience in valuations and equity analysis.
Garima Arora is an Associate in the Valuations practice of Ernst & Young India. She has cleared CFA Level 3 and has three years of experience.