Franchise business can’t be valued using traditional tools
Updated: Aug 9, 2021
There are so many analysts who devote time to understand the fair value of businesses. However, it may not be possible for an analyst to come out with a precise franchise business value.
The logic is simple, these businesses are compounding machines, and as far as they are focused right, they will continue to create massive wealth for their shareholders.
We will look at two methods to understand the value at which a franchise business may become attractive.
Method 1: Reverse Discounted Cash Flow (DCF) method
One of the easier ways to assess the value in these businesses is to understand what the market is expecting. This is also called the reverse DCF method.
Let’s look at few companies to understand this better.
The recent FCF growth is about 24%. The market expectation is similar to the historical FCF growth. Although market expectation is in line with historical FCF growth trend, however 24 percent p.a. for the next ten years is too high. Analysts should be able to evaluate the growth expectations in the context of changing habits to boost immunity etc.
If you invest in a high-quality business, the possibility of creating massive result will outpower the extra price paid. There is a reasonable chance high-quality businesses never become available at an affordable price.
As a next step, we can understand the expected rate of return for these franchise businesses. You are not trying to forecast but rather the expected rate of return if you were to invest in such a business.
Method 2: Expected Rate of Return
Before I proceed to the breakup value, it is vital to understand the baseline return. In finance terms, it is called an opportunity cost. If you invest in one business, you forgo investing in other companies or investment options. What could have been your return on those investment vehicles?
A simple baseline is the government bond, i.e. long term government bond. This is also called risk free return, the ultimate baseline. If you were to return similar to a government bond yield, why do you want to invest in equities. You may want to earn 4-5% extra than a government bond.
Depending upon the business quality, the baseline rate for a franchise business would be 10% - 14%. I would assign 10% to a large company and 14% to a small company. Note that irrespective of the market cap, these businesses are growing their sales more than 7% year on year plus generate an RoI of more than 15% every year with minimal or zero net debt.
The logic is simple, as far as the return is more than the base return, you should be comfortable investing in that particular business—the difference between the company return and baseline return is the Margin of Safety.
Let’s see this in action.
We break up the value of return as:
Cash Return: Simply speaking, it is the dividend paid by the company.
Organic Return: This includes return due to the organic growth of a company.
Investment Return: This attributes return due to the investments made by the company.
The total of these returns is to be compared with the baseline return.
Amrutanjan Healthcare Ltd
The average dividend payout ratio for the last five years is 33%. I have taken 2020 as the base for the calculation. The average NOPAT growth over the previous five years is 7.7%.
Cash Return = Payout Ratio X NOPAT Growth (%)
Cash Return = 33% X 7.7% = 2.5%
Organic return, in simple terms, is the sales company can generate from its core business. The average sales growth in the previous five years (2016-2020) is 10.7%. When a business, grows it has to invest as well. Amrutanjan has risen 4% higher than inflation in India. If we assume inflation to be 5-6%, plus 4% is 10%. We may not be that off from our assumption of 10.7% sales growth.
If a company sales increases, a company may run out of current capacity and have to build more. This is called capital expenditure. Additionally, they will have to invest more in inventory, their receivables and payables will increase too.
In the case of Amrutanjan, average (2016-20) Capex to sales is 1.2%, average (2016-20) receivable to sales is 12%, average (2016-20) inventory to sales is 5.8%, and average (2016-20) payable to sales is 11.8%.
Investment to get more sales = 1.2% + 12% + 5.8% - 11.8% = 7.2%
Using 2020 base sales of Rs 261 crores, growing at an average of 10.7%, will generate additional sales of Rs 27.9 crores. The company may have to invest 7.2% of Rs 27.2 crores, i.e. Rs 2 crores, for additional sales generation.
Effectively, the sales after considering the associated expense is 10.7% X (1 – 7.2%) = 9.9%.
We may be looking at a different trend in the future since Amrutanjan is a health product company. The pandemic has forced people to think about immunity, hygiene etc. There is an almost 27% jump in 2020-21 and 190% in NOPAT (ignored in the calculation above). If you believe that the trend is sustainable, then the cash and organic return will increase.
Inorganic or Investment Return
After paying dividend and investment for organic growth in capex and working capital, a company is still left with some money. A franchise business would often have a problem of ‘’what to do with all the cash”. The surplus funds should be used to grow. The investment may happen in the form of acquisition.
Interestingly, a lot of companies are not good with acquisitions. The idea is that a company should be earning better than its existing business. This may be quite hard given the company is already a high ROI company.
In March 2011, Amrutanjan Health Care Ltd acquired the Fruitnik brand for Rs 26.2 crores. It’s been almost ten years, and this brand has been eating the profits of the company. During the recent analyst call, management has indicated a better future for Fruitnik. The best-case scenario would be 15% ROI.
For the sake of calculation, we will base the surplus cash available on 2020 data. In 2020, NOPAT was Rs 19.5 crores for the company. After distributing Rs 6.4 crores to shareholders, 33% of Rs 19.50 crores, and using Rs 2 crores to support organic growth, management would be left with ~Rs 11 crores sustainable earnings for active investment. If I assume in the next few years, the operations of acquired businesses be 15% ROI, it will generate Rs 1.65 crore. The company's current market capitalisation is Rs 2,000 crore, i.e., an inorganic or active investment return of 0.08%.
Total return = cash return + organic return + inorganic return
Total return = 2.5% + 10.7% + 0.08% = 13.3%
Amrutanjan is a small company. Therefore, I will assign a 14% base rate. The total return is less than the base rate, leading to a negative or no margin of safety.
If we consider 2021 performance and assume it to be sustainable, most of the cash is allocated towards ‘active investment’. The company so far does not have too many acquisition records. Therefore, we should not base our decision only on one acquisition. At this stage, assigning too much value to active return should be avoided.
There is a possibility that if the company does not need cash, it may decide to distribute to shareholders. Additionally, Capex and working capital may require investment if the company sees 2020-21 sales increase to be more sustainable. Based on 2020 data, investment in the company is not recommended due to zero margin of safety, however 2021 jump in cash flows changes everything.
You must be wondering why I have not used Price to Earning, Price to Book or Enterprise multiples. Most of the high quality company will command a very high multiple due to high growth expectations and high ROCE. If you reply of multiple, you will not be able to make investment decision in these high quality companies.
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