By Keith Ashworth-Lord, Chief Investment Officer, Sanford DeLand
Growth is one of the characteristics we look for in a quality business. However, there are caveats to this and care is needed. Investors have a preoccupation with growth, but few understand its true importance. If you were to ask why growth is important to business valuation, few would be able to give a precise answer. Nearly all would say growth in sales, profits and earnings – and little else – is what drives share prices.
Most observers believe an expanding business is also expanding value creation but this is not necessarily so. Companies can grow yet still destroy owner value. Focusing on growth alone neglects the equally important concepts of profitability of capital and free cash flow.
The traditional accounting model of company valuation says that share prices are determined by capitalising accounting earnings at an appropriate price-to-earnings (P/E) ratio. The accounting model centres on the income statement and balance sheet. For the E calculation, it matters if a cash outlay can be capitalised in the balance sheet rather than expensed through the profit and loss account. And what other than comparison to some other company, or investment class, determines the appropriate multiple of E to get the P? By contrast, the economic model of company valuation focuses on the sources and uses of cash. So, it doesn’t matter where the cash outlays get recorded.
We therefore care only about how much cash seems likely to be generated over the lifetime of the business and the risk that it won’t materialise. Growth is important in that a good business will be able to expand its cash earnings (effectively its coupon) at a higher rate than the discount rate used to bring those future earnings back to present value.
But profitability is also important. Take two businesses, for example: Berkshire and Hathaway. Both currently have the same earnings and are expected to report the same growth rate. Should they be valued on the same PER? Suppose that Berkshire has to invest twice as much capital as Hathaway to achieve that growth rate. Or put another way, for the same amount of capital invested, Hathaway generates twice the rate of growth as Berkshire. Should Hathaway command twice the PER of Berkshire then? Berkshire is spending its way to the growth that Hathaway manages to achieve by more efficient use of capital. A capital-intensive company may need to use much of its cash flow to reinvest in productive assets to maintain its earnings power.
Conversely, a company with a different shape may have very little fixed asset needs so that its cash flow becomes available for acquisitions or returning to shareholders as dividends or buy-backs. Cash flow only becomes really valuable once it becomes distributable.
Managers of companies with slower intrinsic growth can boost their apparent returns by throwing more capital at the business. At the personal level, investors can think of it like this. Suppose they wish to grow their income by £10 next year and they have £400 of spare cash left over from last year’s endeavours. They can obtain that £10 of growth by investing £200 in a 5% savings account and then go out and enjoy spending the other £200. Alternatively, they can deposit £400 in a 2.5% savings account and still produce the extra tenner at the year-end. Which makes the greater business sense? It is obvious: invest at higher returns and pay yourself a dividend.
This throwing of more capital at the business is often done by acquisitions, which make less than ideal business sense. Worse still, if that capital is earning less than its opportunity cost, any growth produced actually destroys owner value. Clearly, there is more to growth than meets the eye.