Key Points
- Analyzed the premium valuations of MNC subsidiaries in India relative to their overseas parent companies.
- Examined the current valuations and calculated the implied future growth in cash flows.
- Calculated the differential growth rates in free cash flows required for Indian MNC subsidiaries to justify their higher valuations relative to their parents.
- Compared EV/EBITDA multiples for MNC parents and MNC subsidiaries to justify their elevated valuation.
- Explored the potential factors affecting the growth and profitability of MNC subsidiaries in India.
Last month, an analysis was conducted to determine whether the premium valuations of multinational company subsidiaries (MNCs) in India, compared to their overseas parent companies, can be attributed to a superior growth profile or other factors such as excess domestic liquidity.
The analysis involved comparing the valuations of the MNC parents and MNC subsidiaries from a decade ago to their subsequent cash flows.
The conclusion drawn from the analysis was that the superior growth profile of MNC subsidiaries explained a significant portion of the 75% premium multiples they traded at in December 2008.
In this article, we aim to gain insights into the current valuations of these two sets of companies and calculate the implied future growth in cash flows that the current valuations are pricing in.
From 2009 to 2020, the valuations of MNC subsidiaries experienced significant growth, expanding by more than six-fold. As of June 30, 2020, the set of Indian MNC subsidiaries in the sample had achieved an enterprise value (EV) of US $167 billion, with a Compound Annual Growth Rate (CAGR) of over 17% from their EV of $27 billion on December 31, 2008.
In contrast, the EV of MNC parents on June 30, 2020, was US $3,114 billion, with a more modest CAGR of 5.7% from their EV of US $1,634 billion on December 31, 2008.
Investors are now faced with the question: Are the current valuations accurately reflecting the expected future growth?
To address this question, the differential growth rates in free cash flows required for Indian MNC subsidiaries to justify their higher valuations relative to their parents were calculated. It was assumed that the growth outperformance of MNC subsidiaries will continue for the next 15 years and then disappear, at which point MNC subsidiaries will grow at the same rate as their parents. This period of 15 years constitutes the explicit forecast period and is followed by a perpetuity/terminal year, as per the discounted cash flow (DCF) model.
Additionally, the real weighted-average cost of capital (WACC) for each MNC subsidiary was calculated to be the same as its parent. Considering that the subsidiaries’ cash flows are in Indian rupees (INR), their WACCs in INR were determined by adding a premium of 3.5% to the WACCs of their parents to reflect the inflation differential between India and the developed economies. Furthermore, a perpetuity growth rate of 1% for MNC parents and 4.5% for their subsidiaries was anticipated.
The starting point for calculating the companies’ future cash flows is the actual cash flows they earned in the year ending 31 December 2019 / 31 March 2020. In cases where the current year cash flows deviate significantly from historical cash flows due to one-off factors, an average of historical 10-year cash margins (free cash flow to the firm (FCFF)/net sales) on the last financial year’s net sales was computed and applied to calculate a normalized cash flow, which was then used to extrapolate the cash flows for the next 15 years.
Great Expectations
As of June 30, 2020, the MNC parents traded at 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 sharp increase from 14.8x on December 31, 2008.
To justify their elevated valuation, MNC subsidiaries have to grow their free cash flows at a cumulative average rate of 13.1% for the next 15 years, while their MNC parents only need a 2.2% Compounded Annual Growth Rate (CAGR) over the same period. Therefore, the MNC subsidiaries must achieve a differential growth rate of 11% per annum for the next 15 years.
Considering that the Indian economy should optimistically achieve a long-term growth rate of about 6% to 8% per year, and assuming a 3.5% inflation differential between India and the developed economies, the 11% growth is feasible but somewhat ambitious.
This growth pertains to free cash flows rather than profits. Achieving double-digit profit growth would necessitate a corresponding increase in turnover, as the scope for margin expansions may be limited. This would require substantial investment in capital assets and net working capital.
Conversely, the reduction in India’s marginal corporate tax rate from about 34.6% to 25.2% in August 2019 should help generate higher free cash flows, considering that most MNC subsidiaries previously paid the highest effective tax rate.
During the period from March 2009 to March 2020, the free cash flows of MNC subsidiaries grew at a CAGR of approximately 8%. It is acknowledged that the 2010s, described as “India’s Lost Decade” by various commentators, have not been conducive to substantial corporate profitability growth.
There is optimism that the future will be better, and the MNC subsidiaries will justify their growth premium.
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All posts represent the opinion of the author, and should not be considered as investment advice. The opinions expressed do not necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images / Ashwin Nagpal
