Last month we analyzed whether the premium ratings of multinational subsidiaries (MNCs) in India compared to their foreign parent companies are due to a superior growth profile or other factors such as excess domestic liquidity.
Our method? Compare the ratings of MNC parents and MNC subsidiaries from a decade ago with their subsequent cash flows.
Our conclusion? That the superior growth profile of the MNC subsidiaries explains a majority of the 75% premium multipliers they traded in December 2008.
Here we will examine the current valuations of these two groups of companies and calculate the implicit future growth of cash flows that price the current valuations.
The ratings of the MNC subsidiaries developed very well in the period from 2009 to 2020 and increased more than sixfold. On June 30, 2020, the sample of Indian MNC subsidiaries in our sample had a company value (EV) of $ 167 billion. The MNC subsidiaries rose from their $ 27 billion EV on December 31, 2008 with a CAGR of over 17%.
In contrast, the EV of MNC parents as of June 30, 2020 was $ 3,114 billion, up 5.7% from the EV of $ 1,634 billion on December 31, 2008.
The question is: are investors correctly assessing the expected future growth of current valuations?
To answer this, we calculated the different growth rates of free cash flows that Indian MNC subsidiaries need to justify their higher valuations compared to their parents. We assumed that the growth performance of the MNC subsidiaries would continue over the next 15 years and then disappear. At this point, the MNC subsidiaries will grow at the same rate as their parents. In the parlance of the discounted cash flow model (DCF), the first 15 years form the explicit forecast period, followed by an unlimited / final year.
We also calculated that the real weighted average cost of capital (WACC) is the same for each MNC subsidiary as for its parent. With subsidiaries ‘cash flows expressed in Indian Rupees (INR), we determined their WACCs in INR by adding a 3.5% premium to their parents’ WACCs to reflect the inflation differential between India and industrialized countries. Similarly, we expected MNC parents to grow at an eternal rate of 1% and 4.5% for their subsidiaries.
Our starting point for calculating companies’ future cash flows is the actual cash flows they achieved in the fiscal year ended December 31, 2019 / March 31, 2020. If the cash flows of the current year are abnormal – either significantly above or significantly below the historical cash flows due to one-off factors – we have an average of the historical 10-year cash margins (free cash flow for the company (FCFF) / net sales) on the Net sales of the last fiscal year calculated and applied to calculate a normalized cash flow, which we then used to extrapolate the cash flows for the next 15 years.
As of June 30, 2020, the MNC parents had an EV / EBITDA multiple of 10x compared to 8.5x on December 31, 2008. The MNC subsidiaries were valued at an EV / EBITDA multiple of 29.4x, a significant increase of 14.8x compared to December 31, 2008.
To justify their increased valuation, MNC subsidiaries must increase their free cash flow over the next 15 years at a cumulative average rate of 13.1%. Your MNC parents only need a 2.2% CAGR over the same period. Therefore, the MNC subsidiaries must achieve a different growth rate of 11% pa for the next 15 years.
Since the Indian economy (optimistically) should achieve a long-term growth rate of around 6% to 8% per year and an inflation difference of 3.5% between India and the industrialized countries is assumed, this growth of 11% is possible, if somewhat ambitious.
Of course, this is a growth of free cash flow, not profit. Investments in capital assets and net current assets are deducted from the cash profit to calculate the free cash flow. Double-digit profit growth would require a corresponding increase in sales, as the scope for margin expansion could be limited. This would require large investments and investments in working capital.
On the other hand, lowering the Indian corporate tax rate from around 34.6% to 25.2% in August 2019 is likely to contribute to higher free cash flows, as most MNC subsidiaries paid the highest effective tax rate.
From March 2009 to March 2020, the free cash flow of the MNC subsidiaries increased by around 8%. Admittedly, the 2010s – referred to by various commentators as “India’s lost decade” – were not a great era for corporate profitability growth.
We can only hope that the future gets better and the MNC subsidiaries justify their growth premium.
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All contributions 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 the CFA Institute or the author’s employer.
Photo credit: © Getty Images / Ashwin Nagpal
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