Company Valuation Under IFRS : Interpreting and Forecasting ...

Company valuation under IFRS
Exhibit 1.7: Possible cash flows (2)
Possible Cash Flows
Dividend
C
B
A
Time
So, there is a trade-off. We can have more cash distributed to us now, but accept
that the stream will grow more slowly, or we can take less out of the company
now, let it reinvest more, and enjoy a higher rate of growth in our income. What
sets the terms of the trade-off? The return that we make on the incremental equity
that we are reinvesting.
There is a formula for this (with, again, a proof in the Appendix). This is it:
g = b*R
where g is growth, b is the proportion of profits that are reinvested in the
business, and R is the return that we make on the new equity.
Notice, incidentally, that the return that we make on new equity does not have to
be the same as the return that we are making on existing equity. Suppose that we
had a wonderful niche business making fantastic returns, luxury shops on ideal
sites, for example. It might be that they could continue to produce a very high
return for us, on the existing investments. But if we were to invest some of the
profits in new sites, perhaps less good ones, then our returns on new equity would
be below that on the existing equity. It is the return on the incremental equity that
generates the incremental profit.
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