Podcast Transcript

Today we will be looking at a company’s growth and how we can forecast its expected future growth rate. We will be using the compound annual growth rate formula to calculate the growth rate. I also have a few additional tools we can use to calculate the expected growth of a business in the value investing spreadsheet I created to help me value a business. It is free to download from my website at www.growthwithvalue.com/tools, I have provided a link in the show notes.

Some things to consider when forecasting the growth of a business is to first take a step back and look at how well the economic environment has suited the business that you are analysing. For example, in times of low interest rates, which tend to encourage higher consumer spending, there will usually be better returns and greater revenue for retail businesses and alternatively, if interest rates are relatively high or climbing, people will tend to limit their discretionary spending. Another influence on the growth of a business could be if it was in a rapid expansion phase, e.g. opening many new stores and growing market share. This too would be reflected in high growth in earnings of the business and you would need to consider how long the business could continue to grow at this rate. Other things like changing commodity prices such as oil, can have either a positive or negative impact on the bottom line and in turn the growth of a business, depending if it is a producer or consumer of the commodity. Also, movements in currencies can affect the businesses growth. For example, if a large proportion of the business revenue is dependent on international sales, or if it exports most of its produce, then any rise in the local currency could negatively impact its sales. Also, the business may have previously had a strong economic moat and this can be affected by changes in technology or an increase in competition which could greatly reduce the growth of a business.

Having a detailed checklist can insure you consider the numerous issues which may influence the future growth of a business. These issues could be easily overlooked and not taken into consideration when calculating the company’s growth. It is always better to be conservative when forecasting the growth of a business and if you decide to invest in the business, incorporating a larger Margin of Safety to help protect your investment in the event there are circumstances in the future that negatively impact on the value of that investment.

I use the Compound Annual Growth Rate formula when projecting the future likely growth rates of a company. This basically means using the growth rates from previous years and then projecting them forward. There are obvious flaws with this method, as just mentioned in the points above, because the economic conditions and environment in which a business operates can easily change. As Warren Buffett has said “The investor of today does not profit from yesterday’s growth”. Having said that, regardless of its flaws, using the Compound Annual Growth Rate of a company to project its future growth rate provides us with a simple method that is not easily manipulated. That is why it is very important to know and understand what exactly the business does. You also need to be comfortable in recognising how the business operates and then use this knowledge to help you project the future growth of a business. By using the Compound Annual Growth Rate of a business’s free cash flow for example, you can see how the business has performed over the last few years and then relate that to the economic conditions the business was operating under at the time. If you believe these conditions can continue or even improve over time, then it is safe to assume similar growth rates. If, however, the conditions that were previously present seem unlikely to continue, you will need to take this into consideration when analysing the growth of the company.

The Compound Annual Growth Rate formula is versatile and simple to use and suits just about any scenario which requires a growth figure. By averaging the growth rate over a period, the formula helps adjust for any distortions that could be caused by the occurrence of abnormal annual results from the business. However, it can be limiting to screen out completely any volatility in a company’s financials. In particular, when calculating a company’s growth rate, it pays to be aware of how consistent the company is growing its earnings, as this will give you confidence in the company’s ability to keep growing at that particular rate.

The Compound Annual Growth Rate formula is as follows:

CAGR = ((Ending Value)/(Beginning Value))^((1/(Number of Years)))-1

Where:

Ending Value = Last published EPS, Dividend or Free Cash Flow figure
Beginning Value = First EPS, Dividend or Free Cash Flow for the chosen period
Number of years = Number of years between the Beginning Value and the Ending Value.

Other considerations would be how the company has grown its earnings, be it through organic or inorganic growth. Organic growth is when a business expands its operations using its own resources and capital and opens new stores or expands the size of its current stores for example. Organic growth tends to have less of an impact at inflating earnings as much of the investment is expensed through depreciation which reduces earnings. It also won’t affect Free Cash Flow as we deduct Capital Expenses from Operating Cash Flow to calculate Free Cash Flow.

A company may also increase its earnings through inorganic growth. Inorganic growth comes when a company looks to acquire other businesses to increase the size of the company and also its earnings. An example may be if we have a shoe store which has increased earnings each year by about 5%, if this company made a profit of $1,000,000 last year and it has recently bought another identical shoe store that also produced $1,000,000 in profit, this will result in the business reporting a 100% increase in its earnings. If you are not paying attention you may think this shoe store is an amazing business and has an exceptional growth rate. If you apply this rate of growth when you calculate the intrinsic value of the business you will find that your calculation produces some very high numbers.

This is why it is important to look back over the previous financial reports to see how the business has been growing and be sure to include only the growth of existing stores or stores that have been operating for more than 12 months. Often managers will report same-store-sales, which looks at the growth of stores that have been in operation for a certain time period, usually at least 12 months. This is in addition to looking purely at revenue or earnings growth which may have had a boost from a recent acquisition. Think back to that shoe store example, it has seen a 100% growth in earnings, but for all we know the existing shoe store sales could have been flat or declining, same with the newly acquired store. But this has been hidden if we just look to the revenue or earnings as a whole and not at the individual stores themselves.

As mentioned before, organic growth will likely have less of an impact on boosting earnings as the capital expense is deducted from revenue on the income statement through depreciation. It also wont boost Free Cash Flow as it is considered a capital expense given we deducted CAPEX from Operating Cash Flow to give us Free Cash Flow. Inorganic growth on the other hand has the ability to bypass Capital Expense by recording the acquisition in the Cash Flow from Investing section of the Cash Flow statement under Purchases of a Business, Subsidiary or Investment. None of these are deducted from the normal calculation of Free Cash Flow, so as an investor we must pay attention to how a business is growing and allocating its growth related expenses.

When it comes to calculating a business’ intrinsic value we will normally apply two growth rates. First we will apply a high growth rate for an expanding business, second we will apply a terminal growth rate which is applied through to perpetuity.

In most scenarios, when a company is still expanding and increasing its market share it will be growing its business and thus increasing its profits at a greater rate than that of a well-established company. It is up to the investor to decide if a company still has the capacity to grow market share, or whether it has reached maturity and will continue to grow its revenues at a more subdued rate.

There are two types of growth periods just mentioned; the first relates to a company that still has the capacity to grow revenues rapidly and this is referred to as the High Growth Period. It is up to the investor to decide the number of years they believe the business can maintain these higher rates of growth. It is often the case investors assume the Higher Growth Period will last for no more than 10 years. It is important to reiterate, the High Growth Period is just a forecast which has the high probability of being impacted (both negatively and positively) by many unforeseen scenarios, which in turn, would impact a business’s growth rate. For this reason, forecasting past a 10-year period would also come with a much greater risk of being affected by any unforeseen events, no matter how great the business may appear to be.

Once it is anticipated that the business has reached the end of its High Growth Period, the investor will then adopt a Terminal or Stable Growth Period for the business where the Growth Rate will be more modest. Mature businesses are easier to value as they are more predictable than a younger expanding company. This can be obvious when reviewing a mature company’s Financial Statements, as the reportable figures such as Revenue, Net Profit, Assets and Liabilities will generally be more consistent with fewer fluctuations and with steadier growth than that of a younger business. This doesn’t mean that they don’t come with less risk, as mature businesses, if not properly managed, could be left behind in an ever-changing market. Once a business reaches maturity it is generally accepted that a growth rate just above inflation is appropriate; therefore, a Stable Growth Rate of between 2% – 5% is often used when calculating Intrinsic Value.

For many mature businesses that have been operating for decades, I will usually still include a High Growth Rate/Period in my formula which will ensure that I include those companies that have continued to produce above average returns greater than the Stable Growth Rate of 2% – 5%. By including a High Growth Rate in my Intrinsic Value calculation, I will avoid undervaluing a great business with a proven ability to achieve above average returns by including a High Growth Period and not just calculating the business’s Intrinsic Value using the Stable Growth Rate of 2% – 5%. I will also avoid any overvaluations or increased investment risk that would occur by using the company’s current high growth rate in place of the Terminal/Stable Growth Rate. This would give us an unrealistic Intrinsic Value of the business.

As it is not feasible to continue calculating the High Growth period too far into the future due to the increasing challenge of accounting for changes in the market and economy, we therefore revert to the Terminal/Stable Growth Rate as mentioned above, using 2% – 5% growth per annum from thereafter. This is an attempt to value the future cash flows of the business into perpetuity, notwithstanding it is not possible to know how long the business will continue its operations into the future.

In summary, we have established that it is important to properly understand the business and its operations to help guide our decision on applying an appropriate rate of growth for the business into the future. We use the Compound Annual Growth Rate formula to calculate the historical growth rate of the business, using either Earnings per Share, Free Cash Flow or dividends, or a mixture of all three, with the result being a good basis to use as the future growth rate of a company. We also understand that the past performance of a business does not always equate to the expected future growth of that business. Again, this is why we need to properly understand the business and the economic environment in which it operates. We also discussed the importance of organic versus inorganic growth and how inorganic growth through acquisitions will provide an unsustainable boost to a company’s earnings. Finally, we discussed two separate growth periods, a high growth period and a terminal or stable growth period. The high growth period is used to apply a higher rate of growth to project the earnings of the business over a given period of time, usually less than 10 years. Terminal growth is a rate of growth usually inline with inflation and is used to calculate the projected earnings of a business into perpetuity, after first accounting for a period of higher growth.