Biases in McKinsey Value Driver Formula Part 2 – Inflation Distortions

I go a little crazy with these two value driver formulas because the equations only accurately measure value in with highly constrained assumptions. Two of the absurd assumptions are that there is no inflation at all and that the growth rate over time is constant. When these assumptions are not made, the formula does not accurately compute value. To demonstrate this I have made a series of videos and worksheets related to the formulas with different alternative calculations. When the value driver formula is adjusted for inflation, the formula becomes:

P/E = [(ROE-g)/(k-g)] * [(1+inflation)/(ROE-inflation)]

P/E 1 = [(ROE-g)/(k-g)] / [ROE-inflation]

The video below on the left addresses the inflation issue associated with the value driver formula. The video is associated with the file available for download below that is named “Inflation and Value Driver Formula.” An excerpt from the file shown below this paragraph demonstrates the errors in the value driver formula associated with inflation. The file is built up from a long-term analysis where real and nominal returns, growth rates and the cost of capital remain constant. The first scenario computes the equity value assuming that the nominal returns are realised in cash and used to payout dividends. The next simulation uses real rates rather than nominal rates and results in a different P/E ratio. The third simulation adjusts the nominal value for asset value increases that result from inflation. Inflation in assets does not produce cash to pay dividends but, as it is the base for computing ROE, it increases dividends over time. The excerpt shows that the P/E ratio and the value derived from multiplying the value driver formula by income can understate value by a wide margin.

Excerpt ROIC and Inflation.JPG

The video below on the right addresses biases in the value driver formula when the ROIC on existing net invested capital is different from the ROIC on new invested capital that has been termed RONIC (as if you can really segregate this — what rubbish). This transition video is associated with the file available for download below that is named “ROIC Transition Problems.” An excerpt from this file below demonstrates the errors in the value driver formula from changes in returns. The transition formula file simulates net investment from existing and new assets given a growth rate in net invested capital. The new investment is applied the return on existing assets and the new assets are assumed to earn the RONIC. When this is all put together with depreciation and capital expenditures, the enterprise value can be computed. The valuation from this detailed simulation is compared to the valuation that results from the value driver formula. The spreadsheet demonstrates that when the RONIC is below the ROIC that the value driver formula overstates value by a wide margin. The spreadsheet also shows the value that is generated by the simple constant growth formula with no change in return. If there is no growth, the simple formula produces the same value as the value driver formula. The workbook also includes a simulation where the ROIC is assumed to gradually decrease from current levels to stable levels using interpolation with the INTERPOLATE LOOKUP user defined function.

Exceprt ROIC and Transation.JPG

Videos Associated with Biases and Errors in the Value Driver Formula

Videos that demonstrate biases and errors with the value driver formula are below. The video on the left describes errors associated with inflation. The video on the right demonstrates biases from the value driver formula when the return on new assets is different from the return on existing assets.

I have made a lot of other videos that show how the value driver formula works. The video links are shown below. I am a little worried that some of these videos have poor quality.

Subject Excel File