Session 8: Estimating Growth

Introduction to Growth Estimation

In this section, the speaker introduces the concept of growth estimation and explains why it is important in valuation. The three basic ways of estimating growth are also discussed.

Three Ways of Estimating Growth

• Historical growth: looking at how quickly the company has grown in the past.

• Outsourcing: asking analysts or management what they think the growth will be.

• Self-estimation: estimating growth based on what the company does, how much it reinvests, and how well it reinvests.

Issues with Historical Growth

• Historical growth rates can vary depending on the measure used (revenues, operating income, net income, earnings per share), time period analyzed (last 3 years vs last 10 years), and type of average used (arithmetic vs geometric).

• Scaling up is difficult as companies get bigger.

• High historical growth rates may not be sustainable.

Issues with Outsourcing Growth Estimates

• Managers may not be objective about their own companies and may provide biased estimates.

• Analyst estimates tend to focus on short-term earnings per share and may not accurately predict long-term growth.

Estimating Growth by Looking at the Company Itself

• To estimate future growth for a company, we need to look at how much it reinvests back into its business and how well it reinvests.

• A significant portion of earnings must be reinvested for a company to grow over time.

Estimating Growth Rates

In this section, the speaker discusses how to estimate growth rates by looking at the percentage of net income that gets reinvested back into the company and the measure of how well you reinvest it.

Fundamental Sustainable or Intrinsic Growth

• The growth rate in equity earnings is estimated by looking at the portion of equity onyx net income that gets reinvested back in the company.

• The retention ratio is a simple proxy for estimating what is being reinvested. It's whatever you don't pay out as dividends.

• The return on equity captures how well you are reinvesting your earnings.

Operating Income

• To estimate operating income, look at the percentage of after-tax operating income that goes back into the business in net capex and change in working capital.

• Return on investment capital is used to determine how much you're earning on your investment capital.

• Return number (return in equity or return on investment capital) is a single number in valuation where we're completely dependent on accountants.

Efficiency Growth

In this section, the speaker explains efficiency growth and its implications.

• Efficiency growth occurs when a company improves its return on capital without investing more money.

• Efficiency growth is finite because companies can only become so efficient.

• Companies with low returns and capital are better candidates for efficiency growth because they have more room to improve.

Conclusion

In this section, the speaker summarizes two ways to grow: adding to your asset base and becoming more efficient.

• There are two ways to grow: adding to your asset base and becoming more efficient.

• Adding to your asset base is a sustainable way to grow, while efficiency growth is finite.

Valuing Young Growth Companies

In this section, the speaker discusses how to value young growth companies. The process involves estimating revenue growth, target margin, and reinvestment.

Steps for Valuing Young Growth Companies

• Estimate Revenue Growth: Predict future revenues by assuming a revenue growth rate that is highest in the early years and becomes lower over time.

• Estimate Target Margin: Determine what your margin will be once your company gets roots growth pains by looking at industry averages or the company's history.

• Estimate Reinvestment: Use the sales to capital ratio to estimate how much you need to reinvest each year to achieve revenue growth. Subtract this from after-tax operating income to get free cash flow.

• Check for Sustainability: Ensure that your return on capital in year 10 is a number you are comfortable with. If it is too low, reinvest less; if it is too high, reinvest more.

Key Takeaways

• Growth is an important input but should not overwhelm you.

• Do not put the onus of certainty on your shoulders; make your best estimate using all available data.

• Use the process outlined above to keep valuations in check.