What You Will Learn
- How to calculate growth rate a company for faster valuation and research
- Simple calculation of growth rate using AAPL as an example
How to Determine the Growth Rate of a Company
Growth rate is probably one of the most hotly contested and asked questions regarding companies. Everyone wants to know the growth rate for their stock. Many decisions are based on this number, but how do we know what it should be? Do we just believe Wall Street analysts and blindly accept that companies should perform accordingly for the next 5 years?
Growth Rate of a Company – It is Just A Number
Growth rate is nothing more than just a number. When we discuss growth, we should be talking in respect to the business, operations and management rather than percentages. In other words, growth rate is more qualitative than quantitative. A single growth rate number on Yahoo Finance does not convey anything about that company. It is simply guesstimating that the company will grow at a certain rate for a certain number of years. However, a company can grow due to excellence or fraud and scandals. Look at the rate Enron, Worldcom and Lucent grew during its run up to the peak. All the growth that Wall Street was salivating over was based on ill accounting practices and lies. So just how do you measure and get a grasp of growth?
Growth is Qualitative
Just because Apple sold millions of iPods, now selling millions of iPhones and gaining ground in the PC market, it does not mean that growth will be exponential. I’m always surprised when I speak to AAPL holders how emotionally attached they are to their position. They expect their company to continue growing exponentially and believe that it can have a trillion dollar market cap. I’ve had the same account talking with emotionally attached Google holders.
Growth comes from the companies ability to sell its products, and then convert the cash from sales into profit and ultimately into free cash. It is just crazy to spend $10 to sell a $8 product yet that is what a lot of companies do. If the business is good, sales will go up. If the business if efficient, profit will increase. If management is smart, shareholder orientated and honest, free cash will pile up. Wall Street somehow fails in mentioning this to the average investor. They just don’t care about making you money. They are more concerned with making money for themselves. Are you sure you want to follow their advice?
Scuttlebutt For Growth
Philip Fisher was a growth nut, yet in Common Stocks and Uncommon Profits the whole emphasis of the book was that growth comes from good management and businesses. His ‘scuttlebutt’ technique of questioning insiders, outsiders, customers and competitors about their business methods, strategies etc gave him insight to the potential growth of the company. Thus he was able to find gems such as Motorola and Texas Instruments in the 1950’s and 60’s when they were small caps and hold them for decades and decades which yielded him in excess of 1000% gains!
Growth is Quantitative Only After it is Qualitative
Once you are confident about the direction of the company and its business ability to generate future growth, only then should a quantitative growth rate be calculated. Easy way is to see what the analysts say, and after learning about the company, you may actually disagree or agree. Personally, Wall Streets growth rates based on earnings concerns me. The fact is, to this day, earnings are still manipulated in accounting to a certain degree in order to show better than actual results.
Growth From Cash
If you run a business, you need cash to create profit. You could get cash from investors, from your own bank account, borrow it from your neighbour or just steal it. Whatever choice is taken, without cash a business cannot start or grow. This brings the idea that cash drives earnings and not the other way around. If you have no money, where are the earnings going to come from? The tree outside your window?
It takes money to make money. Making money doesn’t make money.
The Lemonade Business
To emphasise the point, let’s see a simple example. Let’s look at a bunch of kids who open a lemonade stand for one Saturday afternoon. Let’s also assume these kids know nothing about accounting, business, Wall Street or earnings projection.
These kids have no money to start their own lemonade stand. They’ve just realised that they need cash to sell lemonade and make some money. So they find their parents and borrow $100. With the $100, they buy – a table for $60, ingredients for $20, utensils and decorations for $20. After a hot afternoon of sales, they close up shop and count the money. They made $50. The kids tell the parents that they made $50. Unfortunately, the parents(analogy for the market) had high hopes in their children and were expecting $55 total. They are sorely disappointed and decide to sell everything i.e. the tables, jars, cups etc. The sell off brings in $50. However, the kids were still delighted with their $50.
We see that the initial $100 cash was required to create $50 in earnings. This $50 in cash could then be reinvested to create more earnings.
(Sorry for the last bit which doesn’t really fit with the example, but I want to reference it in later posts)
As you can see, cash drives earnings.
Simple Calculation For Growth Rate
So we know a company will grow at a rate it can generate free cash A.K.A Buffett’s ‘owner earnings’. For this reason, the growth rate that I calculate in my valuations, such as the AAPL posts, is based on FCF (actually it was on CROIC but it should be on FCF).
By looking at 10 year histories of the companies FCF, we can see the companies ability to generate FCF. The past is only a indication of the future. There is no certainty that it will perform in this way, yet learning from the past will help in determining the future. The reason for the 10 years data is because we want to invest in businesses which have a steady rate of growth and less likely to be up 30% one year and then -5% the next.
Rather than looking at just one 10 year segment, looking at the 10 year data in multiple year time-frames, as shown in the image below for KSWS, will allow an investor to see the low, normal and high ranges the company had been able to generate FCF. By taking the median of these values, we get a middle of the road growth rate for the past 10 years. Taking a median, unlike averaging, does not skew the number to either the high or low side.
I’ve received quite a bit of scrutiny for looking at the past to determine the future but Buffett articulates it perfectly.
“In the business world, the rearview mirror is always clearer than the windshield.”
Although a growth rate can be calculated from FCF, it is by no means perfectly accurate. A large margin of safety goes hand in hand with growth rate. For the individual investor, as long as your calculations are not 90%-100% off the mark and you have a large margin of safety, you will be sure to beat the market in the long run.
By referring to 10 years data to get an idea of the companies past, many opportunities to invest in fantastic younger companies growing a incredible rates will be lost. But the point of investing isn’t to chase after everything. It is to go for the ones in which you are certain. Everyone has their own style and it is important to find the investment method that matches your own temperament and character.