Value investors like Warren Buffett have only two goals: 1) find excellent businesses and 2) determine what they are worth. But in order to determine what a company is worth, you will have to predict how fast the business will be able to grow its earnings in the future. How to come up with a realistic growth rate for your intrinsic value calculations is what this post is all about.

As the above quote highlights, all your returns depend of the future growth of the company you are investing in. Therefore the growth rate plays a crucial role in valuing a company. Imagine two identical companies which both earn $10 million this year. However, company A will grow its earnings with 15% a year for the coming 10 years, while company B will grow its earnings with just 5% a year. This way company A will be earning $40.5 million in year 10 ($10 million x 1.15^10) while company B will only be earning $16.3 million.

So while both companies started out from the exact same position, I'm pretty sure you would rather own company A than company B. This goes to show how much impact the growth rate has on the value of a company. And it is exactly because the growth rate is so important that we have to be extra careful when inputting one into our calculations. So how can you determine a realistic growth rate for the company you are analyzing?

Analyst Estimates

By far the easiest way to come up with a growth rate is to see what analysts are saying. Analysts are employees of financial institutions who sniff through every available piece of information that is known about a company and then make a prediction about how well they expect the company to perform in the next few years. For example, on Yahoo Finance you can find out that, on average, analysts expect that Apple (AAPL) will grow its earnings at a rate of 12.24% per year for the coming 5 years.

Seems like a great plan to listen to what these analysts are saying, because they are the experts, rights? They studied for years and then had to pass a host of brutal tests and interviews to finally become a recognized financial analyst. Still, research by McKinsey & Co.concluded that Wall Street analysts are as good as always too optimistic.

But what is too optimistic? Well, the authors state that “on average, analysts’ forecasts have been almost 100 percent too high.” 100%!! So if analysts say they expect a company to grow its earnings at 10% a year, the actual growth will most likely be closer to 5% a year. This is an embarrassingly big difference which will render your valuations wholly inaccurate. So while you could use analysts estimates, take them with a grain of salt. Although a bag of salt might be more appropriate.

Source: http://www.businessinsider.com/this-chart-shows-why-wall-street-stock-ratings-are-a-joke-2012-2#ixzz3AAuNrhZy

The sheer lack of sell ratings and the consistently too-high target prices in the above chart further highlight the general over-optimism of Wall Street analysts.

Historical EPS Growth

Another way to get an idea of the future growth potential of a company is by looking at how fast the company has been able to grow its earnings over the last ten years. Let's take Google (GOOGL) as an example. Looking at the company's financials on GuruFocus.com tells us that the company had earnings per share of $0.73 in 2004 and current earnings per share of  $19.37. This is equal to an impressive 38.8% annual compounded growth rate ($19.37 / $0.73 ^ 1/10).

So over the last 10 years Google has, on average, grown its EPS with 38.8% a year. Now ask yourself, is it realistic to expect that Google will keep growing at that rate for the coming 10 years? Keep in mind that this means Google will have to earn 26 times more in ten years time than the $13.2 billion they are earning today! This seems highly unlikely. Even our over-optimistic analyst friends agree and expect a 16.7% growth rate, which is still really good, but not nearly as high as the historical growth rate of 38.8%!

You just can't extrapolate historical earnings growth into the future, because as a company becomes bigger and bigger, it becomes harder and harder to keep up a high growth rate. This phenomenon is called the Law of Large Numbers. So expect growth rates to shrink over time and don't blindly apply historical growth rates to the future.

Return on Equity as growth rate

Imagine Toothpick Inc., a company selling, as you might have guessed, toothpicks. They collect $20 million from investors to manufacture their initial batch of toothpicks. This money shows up on their balance sheet as Shareholders' Equity. With this $20 million they are able to generate $5 million in net income, which results in a Return on Equity (ROE) of 25% ($5 million / $20 million).

Toothpick Inc. now has $20 million in equity and $5 million in earnings. In theory, they could reinvest all of these earnings into the company (such earnings are called Retained Earnings) which would increase their Shareholders' Equity to $25 million. In this case, they grow their Shareholders' Equity by 25% ($25 million - $20 million / $20 million), which is equal to their ROE. The next year they earn a 25% ROE over their now bigger pile of equity, which is why the ROE can be seen as a growth rate.

However, using the ROE as a growth rate would be a severe oversimplification of how things work in the real world. For example, some of the earnings might not be reinvested but paid out as a dividend instead, and some of the earnings might be needed for maintenance and replacement of equipment and will therefore not directly contribute to the growth of the business. Let's look at how we can tweak this ROE ratio to provide us with a more realistic growth rate.

Sustainable Growth Rate

There exists something called the Sustainable Growth Rate. The name suggests that this is exactly what we need, so let's take a closer look.

The Sustainable Growth Rate is the maximum rate at which a company can grow without taking on additional debt. This is good, because we want to invest in companies which are able to fund their growth with their own earnings. The Sustainable Growth Rate is calculated as follows:

ROE x (1 - dividend payout ratio)

It takes the ROE ratio and adjusts it for any dividends that are paid out, because only Retained Earnings (Net Income - Dividends) can be used to grow the business. If Toothpick Inc. would pay out 40% of its Net Income as dividends, their Sustainable Growth Rate would be 15% (25% x 60%). This indicates that Toothpick Inc. should be able to grow at a maximum rate of 15% per year without having to take on additional debt.

A Realistic Growth Rate

However, what we are looking for is a realistic rate at which we can expect a company to grow over the coming years, not a maximum rate. This makes the Sustainable Growth Rate far from perfect. If, for example, the company decides to take on $10 million in Long-Term Debt to generate more earnings, the amount of Shareholders' Equity would remain the same, but the ROE figure would nevertheless rise because of the higher earnings. So ROE is flawed because it does not take debt into account and because ROE is a key input for the Sustainable Growth Rate, it too is flawed. In addition, some of the Retained Earnings will have to be used for the maintenance and replacement of machines, and will therefore not directly result in growth.

So how do we fix this? Well, we could add Long-Term Debt to Shareholders' Equity before calculating the return, which essentially means we are no longer using the Return on Equity but the Return on Capital. This way we take debt into account. Also, we could use Depreciation & Amortization expenses as a proxy of maintenance and replacement costs of machines, and therefore subtract this from retained earnings to get a more accurate view of the amount of money that can be used to grow the business. Let's call this the Sustainable Growth Rate+, which is also what I have implemented in the Intrinsic Value models of the brand-new PREMIUM Value Spreadsheet.

The formula could be written as follows:

(Net Income - Dividends - Depreciation & Amortization) / (Shareholders' Equity + Long-Term Debt)

So is this then the perfect formula for growth? Not quite. We are still basing this formula on a lot of assumptions. That is why I suggest you compare this rate to the analyst expectations and historical EPS growth rate to make sure you are not being overly optimistic. Also, look at how consistent the earnings of the company have been over the past ten years. If earnings have been steadily increasing year after year, you can have a certain amount of confidence in your growth rate. If, however, earnings fluctuate wildly, an accurate prediction is as good as impossible to make and you should use a considerable Margin of Safety in your calculations. Finally, compute the Sustainable Growth Rate+ for the last couple of years to see if it is relatively stable or highly volatile.

Conclusion

In this article I have tried to highlight the importance of growth rates in calculating the value of a company, as well as showing you that it is not an easy task. The key lesson is that there isn't one perfect way to determine a growth rate, but by combining several sources and by being conservative, you should be able to make a realistic estimate of future growth as long as the company has shown consistent, stable earnings. Good luck guys!

Written by

Nick Kraakman

I'm a value investing expert, serial entrepreneur, and educator. For over 10 years I've been studying the strategies of the world's best investors, and in 2013 I started this website to help other investors consistently grow their wealth. I've already trained 20.000+ people through my best-selling investing course.
Read my full story...