While doing valuation work it is always interesting that most of the people start thinking about future growth. The assumption of growth is interesting, because it assumes that you can look at the future very clearly. There are also people that "assume" low growth rates into their calculations, and believed that they are being conservative.
The problem with the above is that Im inclined to think that no one can actually predict what would be the growth rate in the future, at least in a precise mathematical number.
On high growth companies, many valuations include growth rates for 25%, 20% or 15% for long time. Many others utilize a two or three step DCF that includes declining growth rates at various periods of times. While this sounds mathematically correct, I do not think this is a sensible approach.
Many studies and examples tell us that very small portion (Less than 5%) of companies can growth at 15% for more than 10 years. So how can someone be sure if it’s growing at 20%, 18%, or 30%? Here is where Buffett, Munger & Graham, becomes handy.
Buffett likes businesses that he can understand and businesses where he can see 10 years from now. Graham on the other hand believed that he could not put a value of the company, and he also believed that that was not his job, but rather his job was to make sure that he will not loose money. That’s how he came up with the concept of Margin of Safety; since he could not put a precise value to a company, and then he buys with margin of safety and the rest, is up to the market. Don't remember who mentioned this but "I rather be approximately right, than precisely wrong".
So how people like Buffett, see the company ten years from now. Well, basically they don’t care about being precise, what they want is to be sure that the industry and/or the company will be there in ten years and to do this you need to make broad strategic judgments about the future. This is not about thinking if Paychex or Panera will growth 15% in the next 5 years, but rather if both companies will still in business or if the industry will be viable.
Buffett loves companies with moats, basically when discussing moats he performs a broad strategic decision. Buffett lecture to MBA students in Florida (1998) bring some light into this:
"...So I want a simple business, easy to understand, great economics now, honest and able management, and then I can see about in a general way where they will be ten years from now. If I can’t see where they will be ten years from now, I don’t want to buy it".
Based on the above, even though Buffett is the greatest mind in investing, it's impossible that he knows what will be the growth rates in the future for a company. But broadly he can make judgments about viability of an industry or a company in the future. That's the first question at trying to understand a business.... is the industry/company viable? Any moats around?
Also consider that he wants great economics now, not in the future, not tomorrow, but now!.... He does not want a rosy picture; he wants to pay for what is there now.
But if the company is viable and he can see that the company will be in good shape 10 years from now, he knows that if he pays a reasonable price, his returns will come.
There are many questions that we can draw from this: Why to worry about precision on figures?..... What's what really matter? Specific growth rates? No, only broadly strategic judgements. What’s growth? How can you be sure about growth? Is that what’s important?
Thinking more on what I posted in my previous email. I re read Greenwald's thinking on growth. This brings us to a very, very important lesson, for those (like me) that have been "bewitched" by the darlings of growth. Predicting growth is not what seems to be.
Basically Greenwald mentioned the following:
"It takes both high rates of growth, relative to the maximum rate of R, and high levels of profitability, relative to the cost of capital R to generate large levels of growth related value."
Based on the above statement, value created by growth depends on two factors:
1) The profitability of the incremental capital employed. ROC / C;
2) How fast the franchise grows.
If we take Greenwald's formula, trying to detect growth can be an impossible task for any investor.
Let's assume the following numbers for a particular company:
G= 10%
R = 12%
ROC = 25%
Where:
G= Growth
R = Cost of Capital
ROC = Return on Capital
M = Multiple to current earnings power for no growth.
Greenwald's formula is
M = 1-(G/R)(R/ROC)/1-(G/R)
The above numbers give you a multiple of EPV of 3.6. So, if Earnings with no growth equals $100M then the value of the enterprise with no growth equals $800M, then if the company grows at 10% for long period of time, then the value of the enterprise should be 3 times the value of no growth of $2.4B.
But what happens if the company only grows at 8% for long time? The value of the enterprise should be only 2 times or $1.6M (this is a $1B miss in your calculation for only 2% miss on growth)
What happens at 5%? Value drops to $1B...
So, here is why growth needs to be taken not as a precise figure, but only as a margin of safety; Too much variability into results. I guess we can assume safely two things: 1) the industry is viable? 2) If yes, Barriers to entry? Are there any sustainable competitive advantages? The rest is to obtain growth for free.
I think that if we are able to find a company, valued at normalized earnings power assuming no growth. And the company prospects are to keep growing, that should be our margin of safety, providing that ROC can be maintained.
Lesson - Dont pay for growth, unless you understand the business extremely well and know why it should be worth more. Like Greenblatt said" You do not have to go trough life doing that (referring to paying up for growth). I think is harder to do, because you have less room for error.... its hard to do because you can screw up." (See Benjamin Graham below)
Benjamin Graham in an interview back in June 3, 1955 named “How to handle your Money” stated the following when asked about growth:
A Growth Company is one which a) will be expanding its business and its profits at more than the average rate, and b) will in the course thereof be investing a large part of its profits back in the business.
Q: When you get into the growth stocks, you get into a situation where a man needs a great deal of knowledge?
BG: I think so. But even it’s hard to tell how good your knowledge is; because growth stocks lead to the future, and you don’t really ever have any knowledge of the future. You may have a more expert guess that the other man, but it stills a guess. And many mistakes have been made in buying growth stocks on the theory that the future will duplicate the past.
Q: In trying to buy something for long term growth, you ordinarily have to recognize, one that you are taking a chance and, two, you perhaps have to sacrifice income along the way in order to achieve a long term growth. Isn’t that ordinarily the case?
BG: Yes. The chance is basically related to the point that you pay a higher price for a security in terms of its past and current earnings and dividends than you would for non growth securities, and there is always the possibility of disappointment. The company would have to be better than the average company to justify the price you pay for it. Maybe it won’t be, but you think it will.
