The growth rate is probably one of the frequently asked questions regarding companies. Everyone wants to know how much can the company growth. Many decisions are based on this number; many valuation models use growth rate in the calculations, but how do we know what it should be?

 

Growth is Qualitative

When we discuss growth, we should be talking in respect to the business, operations and management rather than percentages. In other words, growth rate is more qualitative than quantitative.

Growth comes from the company’s ability to sell its products, and then convert the cash from sales into profit and ultimately into free cash. It is just crazy to spend $10 to sell a $8 product yet that is what a lot of companies do. If the business is good, sales will go up. If the business if efficient, profit will increase. If management is smart, shareholder orientated and honest, free cash will pile up.

 

The Problem with Bottoms Up Fundamental Models

Growth is a necessary evil.

There’s no way around it because if you don’t factor in growth, nearly everything is overvalued except for small, ugly cigar butts. Growth is only evil because it’s something that no one can accurately pinpoint a growth rate as it’s in the future.

In the stock analyzer, we took the firm stance of applying the idea that;

In the business world, the rearview mirror is always clearer than the windshield. – Warren Buffett

We still hold to this principle when analyzing the financial statements to get into the fine details of how consistent and strong a company is.

After all, managers lie but the numbers don’t. So financial analysis is vital to understand the operating history of the company from a numbers point of view.

 

Calculating Growth Rate

Here’s how we calculate the growth rate. We like to look at 10 years worth of data. It provides enough history to make projections easier and more trustworthy.

Value investors are called fools a lot of times for anchoring on past data as a guide, but that’s all there is to work with. There is no such thing as accurate future data.

Since FCF for the majority of companies is volatile, we calculate the growth rates for multiple periods and then calculate the median of all the periods.

Something like this.

  • 2008-2012 (4 year period)
  • 2009-2013 (4 year period)
  • 2008-2011 (3 year period)
  • 2009-2012 (3 year period)
  • 2010-2013 (3 year period)
  • 2008-2010 (2 year period)
  • 2009-2011 (2 year period)
  • 2010-2012 (2 year period)
  • 2011-2013 (2 year period)

We calculate for each available period in the last 10 years.

Since we dealing with time, instead of using the growth rate formula shown above, the Compounded Average Growth Rate (CAGR) is used.

Then we take the median of all various time periods: trailing twelve months (TTM), last 3 years, last 5 years and last 10 years.

We don’t stop at FCF.

Using the same method, we calculate the growth rate for each period for each of the parameters below:

  • Revenue
  • Gross Profit
  • Operating Profit
  • Profit before Tax
  • Net Profit
  • Operating Cash Flow
  • Free Cash Flow
  • Total Equity

With all these parameters, we obtain a median growth rate for the company for various time periods (Calculated at the far right on the picture above).

 

Sustainable Growth Rate

Theoretically, the company should not grow faster than the sustainable growth rate (SGR) calculated with the formula below:

SGR = ROE x (1 – Dividend-Payout Ratio)

The sustainable growth rate (SGR) is the maximum rate of growth that a firm can sustain without having to increase financial leverage or look for outside financing.

The SGR calculation assumes that a company wants to maintain a target capital structure of debt and equity, keep a static dividend payout ratio, and accelerate sales as quickly as the organization allows.

If a company has a ROE of 15% and a payout ratio of 75%, for example, its SGR is calculated by taking 0.15 and multiplying it by (1 – 0.75), giving the company a SGR of 0.0375. This means that the company can safely grow at a rate of 3.75% using its own revenue and remain self-sustaining. If the company wants to accelerate its growth past this threshold to 4%, it needs to seek outside funding.

The SGR is automatically calculated and we take the average of TTM and last 3FY.

 

Putting weightage to the different growth rate

 

Once all different median growth rate for various parameters is obtained, we try to assign a different weightage to them. TTM and 3FY growth rate get a higher weightage at 30% while the longer-term growth rate of 5FY and 10FY gets a 20% weightage.

With this, we get the [1] Growth rate based on weightage calculated.

We also get the [2] Sustainable Growth Rate calculated in the last line.

The growth rate used in the calculation is based on the scenario selected in the “V – Dashboard” tab.

In the NORMAL scenario, we will take the average of SGR and Median Growth Rate from all parameters calculated above.

In the AGGRESSIVE scenario, we will take the highest growth rate between SGR and Median Growth Rate. While, in the CONSERVATIVE scenario, we will take the lowest growth rate between SGR and Median Growth Rate.

Intuitive, isn’t it?

 

You may also assign your own growth rate by keying the figure on to the yellow cell. 🙂