The Fallible Investor

Why my valuation model assumes a business will only have profitable asset growth for five years  

Searching for the ‘Holy Grail’

I think the most difficult part of valuing a business is deciding what value, if any, to attach to the business’s earnings growth prospects. In this post, I discuss how I value a business’s potential growth. This post is unavoidably quite technical.   

Why profitable asset growth is important to a business’s valuation

As previously discussed, a business’s earnings growth will only be profitable to me if the business earns more on these new assets than the minimum return I need to provide the capital (my discount rate) to fund this growth. For example, when a business’s ROIC is equal to my discount rate, asset growth by the business will have no value to me because the return the business will earn on the new capital will just equal the opportunity cost to me for letting the business use my capital. Thus, while the business has increased in size, simply because it has more assets, the net return to me is zero.   

When a business’s ROIC is lower than my discount rate, asset growth by the business will actually destroy value for me. This is because the business earns less on the new assets than the opportunity cost to me for letting the business use my capital.   

Only when a business’s ROIC is higher than my discount rate is asset growth by a business profitable to me. It will be profitable because the business earns more on the new assets than the opportunity cost to me for letting the business use my capital. As a shareholder, I will receive these additional earnings. I will receive these additional earnings directly, either by dividends, or indirectly, by the business increasing in value because it has retained all or part of these earnings.     

This is a very important point for investors to understand. Many investors think earnings growth by a business is unambiguously good. It is not. In many cases earnings growth will reduce the business’s value.     

What is a business worth without asset growth

A business can be highly profitable and, thus, have a very high ROIC[1] (well above the average return for a commodity business) without asset growth, however, as Costantini points out:   

“If assets do not grow and are not expected to grow, then the asset multiple of any business, however outstanding it is, should be in line with its… relative return” (that is its ROIC/Discount Rate).[2]    

In other words if a business cannot grow its assets the maximum the business should be worth is its Earnings Power Value (Earnings/Discount Rate). This is equal to the business’s replacement value multiplied by the business’s ROIC/Discount Rate.   

Why my valuation model assumes a business can only have profitable asset growth for five years

How do you value growth?

Costantini says:   

“We recommend that any valuation work should always start without any reference to growth … it is always possible to refine the analysis further. However, even if one did nothing else and selected stocks on that basis, the worst that could happen is that genuinely high-growth businesses would be more expensive than they should. Granted, this could be an opportunity cost, but would never lead to a situation where growth stocks are entered at the wrong price in a portfolio or, worse, some stocks are taken for what they are not… Yet we know that growth in assets significantly influences the valuation of high return (ROIC)[3] businesses in particular. There will be, therefore, certain instances where it is necessary to (incorporate growth).”[4]   

Therefore, asset growth is arguably important only for valuing high ROIC businesses. That is Costantini’s view. He says:   

“Growth only really matters for the valuation of the smaller universe of high CROCI[5] (ROIC) businesses… the reason why economic growth only matters to the valuation of high CROCI businesses is easily explainable… only high CROCI businesses can fund growth internally.” [6]   

So what evidence is there that asset growth is only important for high ROIC businesses? Costantini refers to a study by Tobin, which showed the impact of asset growth on the market price of businesses. The study found that:   

“The effect of growth on valuation was marginal, up to 10 times less important than that of economic earnings… the overwhelming marginal factor contributing to the asset multiple is CROCI (ROIC)… this measure accounts, on average, for 77% of the q ratio[7] (asset multiple) in the US from 1989 to 2004. In contrast, growth has a mere 12% weight in the makeup of the q ratio.”[8]   

In fact Costantini believes investors do not usually attach high asset multiples to even high asset growth businesses. He says:   

“At some point, additional growth does not produce additional valuation. Investors in aggregate know better. They know that businesses routinely attempt to get near the sun (i.e. grow very fast) and burn their wings, mainly by accumulating too many financial liabilities. They also know that a real trend growth of more than 10% per annum is already close to three times GDP, which may be called breakneck speed…the market’s conservatism in the price of growth is properly entirely justified… investors seem to be incredibly cautious about the sustainability of above GDP growth rates”.[9]   

I think Costantini is right when he points out:   

“In the end, growth (in assets) of course matters, but nowhere near as much as the average investor thinks…[10]    

How I value growth

Based on this evidence my valuation model is conservative and assumes that a business will only have profitable asset growth for five years. This means that asset growth will, except for high ROIC businesses, only have a small impact on my valuation of a business. I think this is a prudent assumption to make.   

Of course, if a business can sustain an ROIC above my discount rate, and high asset growth, it will, because of compounding, dramatically increase in value and be a wonderful investment. This compounding effect is why Buffett says:   

 “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”[11]   

However, I am no Warren Buffett and I recognise how hard it is to predict which business’s will be able to sustain a high ROIC, and asset growth, over the medium to long-term. If I buy these types of businesses, and I am wrong about the sustainability of their ROIC, and asset growth, these businesses will be a very poor investment. That is why my valuation model is conservative and assumes there will only be profitable growth for 5 years.[12] [13] For most businesses, this means I will value them at close to their earnings power value (Earnings/Discount Rate).   

In conclusion, I think Costantini is right when he says:    

“The asset multiple (Enterprise Value/Replacement Value) …can be used in an efficient and successful way for (valuing) most of the investment universe, despite ignoring growth in assets, in a manner most disturbing for growth reliant investors.” [14]   

 

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[1] A business’s ROIC is its Return on Invested Capital. It tells you how profitable a business has been. It does this by telling you the amount of capital the business needed to produce its profit.   

[2] P176, ‘Cash Return On Capital Invested: Ten Years Of Investment Analysis With The CROCI Economic Profit Model’, Pascal Costantini, 2006.   

[3] All words in brackets in the quotes on this post are my comments. They are not comments from the authors of the quote.   

[4] Ibid at P117.   

[5] See the CROCI definition at: http://www.investopedia.com/terms/c/croci.asp. I use ROIC as a proxy for CROCI.   

[6] P117, ‘Cash Return On Capital Invested: Ten Years Of Investment Analysis With The CROCI Economic Profit Model’, Pascal Costantini, 2006.    

[7] See the definition of the ‘q ratio’ at: http://www.investopedia.com/terms/q/qratio.asp.   

[8] Ibid at P115.   

[9] Ibid at P120.   

[10] Ibid P116.   

[11]‘Letter to Berkshire Shareholders’, Warren Buffett, 1989.   

[12] As Montier points out, theoretically investing in great (high growth) businesses, “… is a good investment. However, identifying growth ex-ante is very difficult. We are all too confident and too optimistic about our ability to pick winners. Growth investing often means buying expensive stocks. Value investing is an admission of our limitations. It offers protection against mistakes, and it outperforms!”, P307, ‘Behavioural Investing’, James Montier, 2007.   

[13] A further problem with assuming that a business’s prior asset growth rate is sustainable is that its historical asset growth rate may reflect rapid consumption of available franchise opportunities. Once exhausted the potential for profitable asset growth can decline dramatically. See P10, ‘Growth delusions’ in ‘Franchise Value: A Modern Approach to Security Analysis’, Martin Leibowitz, 2004.   

[14] Ibid.