Growth Thoughts
Deeper thinking on a concept central to value.
Growth plays a big part in the calculation of value. Yet I see many people using the concept loosely and without tying it to return on capital and reinvestment.
Scenario 1: Earnings Capitalized - No Growth
Question: What is the value of a $100 stream of earnings capitalized at 10%?
Answer: Not surprisingly, the values are all the same.
Now, does it matter what the underlying return on capital is for each company?
If the company isn’t going to grow and will distribute all of its earnings, then no, it doesn’t matter.
This example assumes that each company continues in perpetuity. Sometimes that’s the case, but there are going to be pressures on Company A and C for different reasons.
Company A should be liquidated, and its capital returned to shareholders.
Company B is earning its cost of capital
Company C is earning above its cost of capital. Keeping it in existence or, better yet, growing it, will add economic value.
Two Ways to Grow
There are two ways a company can grow and add value:
Margin expansion. A discrete or limited event
Reinvestment > cost of capital. Which depends on:
Amount reinvested
Duration of investment period
Margin Expansion
Here we have a company whose earnings increased by 10% by expanding margins. Sales remained unchanged. Invested capital (not shown) remained the same, and return on capital increased, too.
It may be selling more units at a higher price or (more likely) it found efficiencies and conducted the same amount of business at lower costs.
In either case, while this growth is real, it can’t go on forever. For earnings to grow by 10% in Year 3, all things being equal, it will need to increase its margin again.
If this new margin profile is sustainable, then the growth added 10% to the value of the firm. This is not recurring growth unless margins can keep expanding. It is a one-time step-up in earnings power.
Growth By Retained Earnings
“This company has earnings of $100 and will grow at 5% per year in perpetuity. Therefore, it is worth 20x earnings or $2,000.”
We now enter fuzzy thinking territory. I see too much bandying about of growth rates without digging into what they imply.
The question must be asked: How will the company grow?
Most businesses require capital to grow. You can’t have your earnings and grow, too (aside from the margin scenario above).
Where does the capital come from? If sustainable, then it must come from earnings.
How much earnings must we give up for that growth? It depends on the return on capital.
A company earning 10% ROC must retain 50% to grow at 5% (5% / 10%)
A company earning 20% ROC must retain 25% to grow at 5% (5% / 20%)
A company earning 25% ROC must retain 20% to grow at 5% (5% / 25%)
At 50% ROC, a company only needs to retain 10% of earnings to grow at 5%
Now invert these figures. It’s obvious but not discussed enough: The higher the return on capital, the more earnings can be distributed while growing.
The Crucial Questions for the Analyst
How much capital can be reinvested in the business?
For how long?
Will the return on capital change along the way?
Assume:
Capital employed of $1,000
Return on capital of 25%
Earnings are then $250
How much is this company worth (at 10%)?
No growth scenario = $250 / 10% = $2,500
5% perpetual growth = $1,000 capital x 5% = $50 retained.
$250 earnings less $50 = $200 distributable earnings.
$200 / (10% - 5%) = $4,000.
Growth has added $1,500 of value. But that value is not free. It required retaining $50 of annual earnings, or 20% of earnings, because the business earns 25% on capital.
10% growth for 10 years, then no growth = 10%/25% = 40% retention required.
$250 x 60% = $150 distributable earnings
Using a simplified convention, because distributions grow at the same rate as the discount rate, each year’s distribution contributes roughly the same present value. So ten years of distributions contribute about $1,500.
Terminal value = $250 at 10% growth, discounted at 10% means Y10 earnings in present value terms will be $250 / 10% = $2,500.
$1,500 + $2,500 = $4,000. Growth has added $1,500 of value.
Scenarios 2 and 3 illustrate that the value of growth depends on both rate and duration. In this simplified example, a ten-year burst of 10% growth produces the same value as 5% perpetual growth.
The analyst’s job is to determine how much capital can be reinvested, what return that reinvestment can earn, and how long the opportunity can last. High-return growth is powerful because it consumes less cash. Low-return growth may consume all the earnings and add little or no value.
Growth creates value when capital can be reinvested above the cost of capital, in meaningful amounts, for a meaningful period of time.
The analyst’s job is to “print the coupons,” to quote Buffett.
More thoughts? Let me know in a private message or leave a comment.
Stay Rational!
Adam
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Great article.