Video Summary
Estimating Growth in Company Valuation: A Key Aspect for Success
Introduction
Estimating growth in company valuation plays a vital role in determining the future potential of a business. While cash flows and discount rates are essential, growth projections take the analysis to the next level. There are different approaches to forecasting growth, including historical patterns, external opinions, and internal estimations based on company dynamics.
Estimating Growth in Company Valuation: The Key to Intrinsic Valuation
- Estimating growth in company valuation is a crucial aspect that determines the future potential of a business. While cash flows and discount rates provide a foundation, growth projections take the analysis a step further. When it comes to forecasting growth, there are three fundamental approaches. Firstly, one can look at historical growth patterns by examining past performance over periods like three, five, or ten years. Secondly, seeking external opinions from analysts and management can help in gaining insights into future growth prospects. Lastly, estimating growth internally based on the company’s operations, reinvestment strategies, and performance efficiency is a proactive approach. This method aligns most closely with intrinsic valuation, emphasizing the importance of understanding the company’s unique dynamics and potential.
Rethinking Growth Estimation in Company Valuation
- When estimating the growth of a company, there are various approaches one can take. Some rely on historical growth trends, while others outsource the estimation to analysts or company managers. However, I propose a different perspective. I believe that growth has to be earned and cannot simply be projected based on past numbers. Historical growth data may not always provide an accurate indication of future growth. The numbers can vary depending on the metric used—revenues, operating income, net income, or earnings per share—and the time period analyzed. Selecting a base year can greatly influence the calculated growth rate, especially if that year was particularly exceptional, either positively or negatively.
Understanding Growth Rates in Company Valuation
- When analyzing growth rates in company valuation, it is essential to distinguish between arithmetic average and geometric average. While arithmetic averages provide a basic measurement, geometric averages allow for compounding and offer a more realistic estimate of growth. However, it is crucial to note that historical growth rates can vary significantly depending on the calculation method used. There are key considerations to keep in mind when evaluating growth. Firstly, growth loses its significance when a company transitions from negative to positive earnings. In such cases, indicating a growth rate becomes meaningless. Secondly, scaling up poses challenges for companies as they expand, making it increasingly difficult to sustain high growth rates. Although historical growth rates provide a useful reference point for valuation, they are not set in stone. Past performance does not guarantee future success. External estimates of growth from managers and analysts can offer valuable insights, but it is important to recognize their potential biases and limitations.
Exploring Fundamental Growth for Companies
- He’s a rotten manager and he’s going to run the company into the ground. Management growth rates, therefore, might not be realistic because managers can’t be biased about themselves or unbiased about themselves—they’re definitely biased about themselves. Analyst growth rates are bad for a different reason. Analysts are focused on earnings per share, they’re focused in the short term, and they often can’t look past the short term. So, if you look at analyst growth rates, they historically have not been very good predictors of long-term growth. I’ve ruled out historical growth. I don’t trust analyst estimates of growth. Where are you going to go for growth? Look at the company itself. For a company to grow over time, it’s got to reinvest a significant portion of its earnings back into the business and it’s got to reinvest it well. In other words, to estimate the growth for a company, I’ve got to look at how much it reinvests and how well it reinvests. Effectively, if you think about fundamental or intrinsic growth, it can come from one of two places. It can come from adding to your asset base, making new investments, and earning a return on those new investments, or it can come from efficiency. Let me take the first of those. When you add to your investment base, you can grow. In fact, to see how much you can grow, I’m going to try to answer those two questions: how much are you reinvesting, how well are you reinvesting? I’m going to try to scale both. Again, to get away from abstractions, let me look at estimating what I call fundamental sustainable or intrinsic growth.
Strategies for Analyzing Equity Earnings and Operating Income Growth
- Growth, equity earnings, and operating earnings are often used interchangeably in financial discussions. When evaluating the growth potential of a company’s equity earnings in the long term, it is crucial to assess the portion of net income that is reinvested back into the company. This reinvestment can be measured using the retention ratio, which is the proportion of earnings retained rather than paid out as dividends. For instance, if a company pays out 40% of its earnings as dividends, it has a retention ratio of 60%. The effectiveness of this reinvestment can be gauged by the return on equity (ROE). A higher ROE indicates better growth prospects. In the case of operating income analysis, the focus shifts to the percentage of after-tax operating income that is reinvested in the business through net capital expenditures (capex) and changes in working capital. This figure reflects how much of the earnings are channeled back into the company for growth initiatives. By evaluating the return on capital, analysts can determine the efficiency of this reinvestment strategy.
Conclusion
Estimating growth in company valuation is a crucial step towards understanding a business’s potential. By utilizing historical data, external insights, and internal projections, one can gain a comprehensive view of where the company is headed. It’s imperative to consider all factors carefully to make informed decisions about investment and strategic planning.