Higher reinvestment rate reflects higher growth rate in earnings for shareholders
When valuing firms, young investors get stuck in understanding the difference between reinvestment rates and retention rates. Let us discuss the difference between the two along with their applications.
Let us see Mousumi Ltd’s (ML) latest data: Dividend Rs 500 crore; Profit After Tax (PAT) Rs 2,000 crore; Earnings Before Interest and Tax (EBIT) Rs 4,000 crore; effective tax rate 30%; Gross capital expenditure Rs 800 crore ; Depreciation and amortization Rs 200 crore; increase in non-cash working capital Rs 400 crore.
It is computed by subtracting the dividend payout ratio from one. For ML, dividend payout ratio is 25% (dividend of Rs 500 crore / PAT of Rs 2,000 crore). Retention rate for ML is 0.75 ( – DPR of 0.25) or 75%. This indicates that ML is retaining 75% of its earnings after tax (or net income) for its future requirements. Growth rate in net income is one of the significant fundamental variables determining the value of a stock.
Growth rate in net income is computed as product of Return on equity (ROE) and retention rate (or one minus DPR). A higher retention rate reflects higher growth rate in earnings for shareholders for a given return on equity projection for a firm. Thus, retention rate is a variable of importance while valuing equity claims of a firm.
It is calculated by dividing the reinvestment of a firm by its after-tax operating income. Reinvestment is the sum of net capital expenditure and change in non-cash working capital of a firm. Net capital expenditure is excess of gross capital expenditure over depreciation and amortisation. For ML, net capital expenditure is Rs 600 crore, i.e., gross capital expenditure of Rs 800 crore minus depreciation & amortization of Rs 200 crore.
Increase in non-cash working capital for ML is Rs 400 crore. Increase in non-cash working capital results in cash outflows (thereby increasing reinvestment) while decrease in non-cash working capital results in cash inflows (thereby decreasing reinvestment). Net reinvestment is Rs 1,000 crore; i.e., sum of net capital expenditure of Rs 600 crore and increase in non-cash working capital of Rs 400 crore. After-tax operating profit is Rs 2,800 crore [Rs 4,000 crore * ( 1- tax rate of 0.30)].
Reinvestment rate for ML is 35.71% (Net reinvestment of Rs 1,000 crore divided by after-tax operating profit of Rs 2,800 crore. So ML is reinvesting Rs 35.71 out of every Rs 100 after-tax operating income. Reinvestment rate is an input in the computation of growth rate in operating income for both debt and equity investors.
Growth rate in operating profit of a firm is calculated as a product of its return on capital and reinvestment rate. A higher reinvestment rate reflects a higher growth rate in earnings for shareholders for a given return on capital projection for a firm. Therefore, retention rate is a variable of importance while valuing total claims (both debt and equity) of a firm.
The writer is associate professor of Finance at XLRI – Xavier School of Management, Jamshedpur