Can a growing company have a growth value?
Updated: Aug 9, 2021
The ultimate problem with investing is forecasting. Academics have tried hard to provide various theories to simplify forecasting. There is no easy way to deal with forecasting. Let’s look at an example to understand.
Terminal value = Free cash flow / (Cost of capital – growth)
Let’s assume free cash flow as 1000 and growth at 4% in case 1 and 5% in case 2.
Terminal value = 1000 / (9%-4%) = 22,222
Terminal value = 1000 / (9%-5%) = 25,000
A difference of 2,778 can be huge, depending upon the context.
An easy way to deal with this problem is to assume growth as ZERO. This would indicate the worth of the company in today’s time without any assumptions about the future.
This can be calculated as Earnings / Cost of capital
Here what we are looking at is a sustainable level of earnings. You are assuming that if the earnings are not growing, what it takes to maintain the earnings. A high-quality business available close to No Growth Value is a great buy.
Estimation of No Growth Value requires significant adjustments to the reported earnings.
1. Exclude “one-time” charges that are not connected to normal operations. This will require you to go through the annual report especially notes to financial statements.
2. The company reports total capital expenditure (Capex) and may not provide a breakup of that Capex to maintain the current operations or grow future earnings. On the analyst call, you may ask this from the management or use depreciation as the proxy of maintenance CAPEX.
Growth Capex = (5-year average PPE / Sales) X 5 year Average Sales Growth
Maintenance Capex = Total Capex – Growth Capex
Please note that these are only approximations. If you develop deep industry knowledge, you may be able to refine these numbers intuitively.
You compare this No Growth Value with Market Cap. Both the values close to each other indicate a clear buy.
There are rare times when this would happen for a franchise business. March 2020 created such an opportunity. When a similar time comes again, just jump in.
Most of the times, the franchise business would have a market cap much higher than no growth value, indicating that the market expects these companies to continue to grow. But then how do we know what price is the right price to pay for such companies.
The information contained on this website and the resources available for download through this website is not intended as, and shall not be understood or construed as, financial advice. You should consult with a financial professional to address your particular information.