On the whole, it makes sense for long-term investors to invest in companies that are likely to grow over the long term.
And an obvious place to look for companies that are likely to generate long-term growth in the future is companies that have generated long-term growth in the past.
But how exactly should you measure a company's historic growth rate?
There are a million ways you could do it, and that's part of the problem. You have to narrow down the number of things you measure and deciding what to measure is not always easy.
Personally, I've usually measured growth as growth in revenues, earnings and dividends. However, I have recently moved away from earnings in search of something else which is a) more stable and b) more closely related to dividend sustainability.
That 'something else' has turned out to be a combination of tangible capital employed (which I'll define shortly) and free cash flows (which I'll define in an upcoming blog post).
Analysing companies with free cash flows and tangible capital employed is a lengthy topic and it will probably take a few blog posts to cover in full, so in this first blog post, I'll just outline the three things I now use to measure a company's growth rate.
1) Measure tangible capital employed growth
If you already know what tangible capital employed is then feel free to skip down to the section on how I actually measure its growth rate. If you're not so sure, keep reading for a quick reminder.
To start with, let's imagine we've started a company together; a barber's shop. We're going to invest some money into the business in order to get it up and running, and we'll hire a professional barber to run the business on a day-to-day basis.
We're going to rent a shop, fit it out with a barber's chair, mirrors and so on. We'll also stock up on scissors, shampoo and the various tools of the barber's trade.
These are all assets of the business. As we buy these assets, we'll record them on the balance sheet.
We expect some assets to last several years, and these are known as fixed or non-current assets.
This could be the barber's chair and perhaps even tools like scissors or shears if they're expensive and long-lasting enough.
Other assets will be used up or turned into cash within a year, and these are known as current assets.
Cash at the bank is already cash, so that's a current asset, but items like shampoo (which will typically be used up within a year) or beard oil (which will be used or sold within a year) are also current assets.
Now imagine our little barber's shop is very busy and we want to expand. One of the main bottlenecks in the business is the barber's chair. We have one chair, so our barber can only cut the hair of one person at a time.
We could hire two barbers and both could cut a customer's hair at the same time, but there are limits to this. You can't have ten barbers cutting someone's hair at the same time and expect to get the job done in 1/10th of the time it would take one barber (or as Fred Brooks said in The Mythical Man Month, "The bearing of a child takes nine months, no matter how many women are assigned.")
If we want our business to carry out more hair cuts and make more money, we're going to have to buy another barber's chair. Obviously, we'll need to hire a second barber (who isn't an asset, at least from an accounting point of view) and that barber will need scissors, shears, shampoo, and so on.
All this will increase our fixed and current assets and that's the point:
Key Point
As long as a company's business model remains approximately the same, the growth of its assets will be a reasonable guide to the growth of the company's "earnings power".
There are few caveats to add at this point.
Caveat a) Ignore intangible assets
Companies can have intangible assets as well as tangible assets. The barber's chair is a tangible asset, whereas an intangible asset could be computer software or (hypothetically) a five-year licence to manufacture and sell Burberry (OTCPK:BURBY) (OTCPK:BBRYF) branded hair clips.
In most cases, intangible assets are quite small relative to tangible assets and I'm happy to ignore them on the assumption that they have no realisable value if the company goes bust (it will be much easier to sell a barber chair than some software developed internally to keep track of customers).
A far more problematic intangible asset is accounting 'goodwill'. Goodwill is the price paid to acquire another company, above and beyond the value of the acquired company's tangible assets.
As a somewhat oversimplified example, imagine our barber shop acquired Burberry outright.
Burberry currently has tangible assets of about £2 billion and a market value of close to £7 billion.
Following the acquisition (which I admit is a tad unlikely), we would record the £2 billion of tangible assets on our balance sheet. The £5 billion difference between the price paid and the tangible assets acquired would be recorded on our balance sheet as an intangible goodwill asset.
This can be a problem because goodwill is not a productive asset. It's just a way to account for the price paid above and beyond the value of an acquired company's productive tangible assets.
This becomes a problem when measuring profitability, which I'll cover in a future blog post. But for the sake of consistency, I'm also going to focus on tangible assets when measuring growth, which means ignoring intangible assets.
Caveat b) Subtract non-interest bearing current liabilities
Another common tweak to assets is to deduct the value of short-term, non-interesting bearing liabilities.
In most cases, this is primarily short-term (e.g. 30-day) interest free credit that suppliers offer to make it easier to sell their wares. In the case of our barber's shop, it's handy to be able to buy shampoo on interest-free credit, use that shampoo to wash some customers' hair and then use the proceeds to pay off the supplier 30 days later.
By deducting short-term interest-free liabilities from our tangible assets, we're effectively pretending we paid for that shampoo (or whatever) with cash, rather than on credit.
Current assets minus non-interest bearing current liabilities is a simplified calculation of working capital, so this final adjustment leaves us with tangible fixed assets plus working capital.
Tangible fixed assets plus working capital is more commonly known as tangible capital employed, and it's the growth of this tangible capital employed that I'm really interested in.
Caveat c) Measure growth on a per share basis
As shareholders, we should be interested primarily in a company's per share results rather than its aggregate results. A company with one factory could, for example, double the number of shares by raising new equity capital in a rights issue, and use that new capital to build a second factory.
This might double the company's tangible capital employed and perhaps eventually its total revenues, earnings and dividends.
However, management may have doubled the company's tangible capital employed, revenues, earnings and dividends, but that doubling would be split across double the number of shares, so it would make no difference to the company's per share results (and potentially no difference to shareholder wealth).
How I measure tangible capital employed growth
So after a somewhat lengthy detour, we can now focus on measuring the growth of a company's tangible capital employed per share.
But there's a snag: In the world of business, everything is volatile. That goes for revenues, earnings, dividends, and yes, tangible capital employed.
And the more volatile something is, the more difficult it is to pick out any underlying growth trends.
For example, what if a company earned 100p per share ten years ago and 90p per share last year. Has the company grown over those ten years or not?
The answer is you have no idea.
Perhaps the latest earnings of 90p are not a good reflection of the company's underlying earnings power (i.e., its ability to generate earnings under 'normal' conditions). Perhaps the company just had a bad year, or we're in a recession. Perhaps under normal circumstances, it could have earned 200p this year, or perhaps 90p really is a good reflection of its current earnings potential.
Simply measuring the change in earnings, tangible capital employed or any volatile value between two single years is not very helpful.
Fortunately, Ben Graham came up with a simple and practical way to iron out at least some of this volatility. It isn't perfect, but it's a lot better than measuring growth between two single years.
Graham's solution was to measure growth between two three-year periods. Here's how it works:
- Get or calculate values for the feature we're measuring going back ten years.
- Calculate the average value for the oldest three-year period.
- Calculate the average value for the latest three-year period.
- Measure the growth rate between those two three-year periods.
Let's run through that process for Burberry (which I've owned for several years and is a holding in my model portfolio), using data from SharePad:
Get or calculate tangible capital employed per share going back ten years
We don't need the whole ten years of data to measure growth rate, but we will need it to measure growth quality, profitability and some other handy ratios which I'll cover in future blog posts. So we might as well grab the data now.
To calculate tangible capital employed per share, we'll need to extract the following values from the balance sheet (there are shorter ways to do it, but I've broken it down a bit more for this example so we can see the different components such as fixed and working capital):
- Total intangible assets (including goodwill)
- Non-current assets
- Current assets
- Current liabilities
- Current borrowings
- Average number of shares in issue (normally found at the back of the annual results in the accounting note relating to earnings per share)
The relevant calculations are:
Tangible fixed assets = non-current assets - intangible assets
Working capital = current assets - current liabilities + current borrowings
Tangible capital employed per share = (tangible fixed assets + working capital) / average number of shares in issue
You can also multiply tangible capital employed (TCE) per share by 100 to convert the value from pounds into pence.
Obviously, this is very laborious, so I've set up a spreadsheet to do most of the work.
Here's a table showing the full set of data for Burberry going back ten years. I've also highlighted the oldest and newest ten-year periods for tangible capital employed per share which we'll look at next:
Calculate the average value for the oldest three-year period
The table above shows tangible capital employed per share for the oldest three years to be 178p, 180p and 203p. The average for this period is then:
Oldest three-year average = (178p + 180p + 203p) / 3 = 187p
Calculate the average value for the latest three-year period
For the latest three years the values are 370p, 390p and 355p. The average is therefore:
Newest three-year average = (370p + 390p + 355p) / = 372p
Measure the growth rate between those two three-year periods
With an oldest three-year average tangible capital employed per share of 187p and a newest three-year average of 372p, I think it's safe to say that Burberry's tangible capital employed per share has grown. But by how much?
To calculate an annualised growth rate, we need to do a bit of mathematical jiggery pokery, which is another area where spreadsheets excel.
The calculation (and conversion to a percentage) is:
((new average / old average)(1/7) - 1) * 100%
The (1/7) bit means raise to the 1/7th power. We do this because there are seven years between those two three-year periods and we're looking for the annual growth rate which, when applied over seven years, would give the correct total growth.
Think of it like this: If we had an annual growth rate and wanted to know the total growth rate over seven years, we would add one to the growth rate (so 18% would become 1.18) and then we'd multiply it by itself seven times (i.e., raise it to the power 7) to get total growth over seven years.
Raising the total growth rate by the 1/7th power and then subtracting one does the same thing but in reverse.
For Burberry the result is:
((372p / 187p)(1/7) - 1) * 100% = 10.3%
In other words, Burberry grew its tangible capital employed per share at an annualised rate of 10.3% over the last ten years.
The chart below shows what that looks like:
Asset growth is good, but unless you're an asset stripper like Gordon Gekko, you're not going to generate a return by forcing a company to sell off its assets.
As shareholders, a company's assets are simply a tool which our hired managers use to generate cash, which they can then return to us in the form of dividends, share buybacks and so on.
But in order to pay out cash, a company first has to suck in cash from the outside world, and that's where we'll look next.
2) Measure revenue growth
Revenue, or turnover, is simply the amount of cash paid into the company by customers in return for the services and products it produces.
Revenue is typically quite stable from one year to the next and without revenue growth a company cannot generate long-term sustainable dividend growth.
Revenue is therefore a prime suspect as a way to measure growth, and it's been one of my key growth measures for many years.
As with tangible capital employed, I'm interested in per share results rather than a company's total revenues.
I also use the same Ben Graham approach to measuring revenue per share growth:
Get or calculate revenue per share going back ten years
Most companies don't quote revenues per share in their annual results, so once again a spreadsheet is invaluable.
Here's a table showing Burberry's revenue per share over the last decade (again, the oldest and newest three-year periods are highlighted):
Calculate the average value for the oldest three-year period
The table shows revenue per share for the oldest three years to be 278.6p, 273.9p and 345.1p. The average for this period is then:
Oldest three-year average = (278.6p + 273.9p + 345.1p) / 3 = 299.2p
Calculate the average value for the latest three-year period
Burberry's latest three revenue per share results are 569.1p, 629.9p and 642.0p, giving an average of:
Newest three-year average = (569.1p + 629.9p + 642.0p) / = 613.6p
Measure the growth rate between those two three-year periods
The total amount of growth between the old and new periods was 105.1% and the annualised growth rate is:
((613.6p / 299.2p)(1/7) - 1) * 100% = 10.8%
A near-11% growth rate is nothing to be sniffed at. It's also satisfyingly close to the company's tangible capital employed (satisfying because we're using these different metrics in an attempt to measure the same thing, which is growth in the company's underlying earnings power and ability to generate excess cash).
So now we've measured growth in the company's tangible capital employed and growth in the amount of money that capital attracts from customers.
The last thing we'll measure is growth in the amount of that money the company is able to return to shareholders.
3) Measure dividend growth
By measuring dividends, we're now measuring three relatively stable aspects of the company which may provide a good indication of the company's intrinsic growth:
- Tangible capital employed growth: Growth of the company's productive physical assets.
- Revenue growth: Growth of the amount of money those assets attract from customers.
- Dividend growth: Growth of the amount of cash the company is able to return to shareholders (returns from share buybacks are reflected in the growth of the company's per share results as the number of remaining shares declines).
Let's take a quick look at Burberry's dividend growth.
Get or calculate dividends per share going back ten years
Most companies do quote dividends per share, although a spreadsheet will still be useful for calculating the dividend growth rate.
As before, here's a (very narrow) table showing Burberry's dividend per share over the last decade:
Calculate the average value for the oldest three-year period
Dividends per share for the oldest three years were 12p, 14p and 20p. The average is:
Oldest three-year average = (12p + 14p + 20p) / 3 = 15.3p
Calculate the average value for the latest three-year period
The latest dividend per share figures are 37p, 38.9p and 41.3p, with an average of:
Newest three-year average = (37.0p + 38.9p + 41.3p) / = 39.0p
Measure the growth rate between those two three-year periods
Total dividend growth between those periods was 154.8%, giving an annualised growth rate of:
((39.0p / 15.3p)(1/7) - 1) * 100% = 14.3%
A 14.3% dividend growth rate is clearly above the 10% or so growth rates of tangible capital employed and revenues.
This means such a high dividend growth rate is unlikely to be sustainable over the longer term, unless Burberry's asset and growth rates can increase.
But this post isn't really about analysing Burberry; it's about measuring a company's growth rate. So let's have a quick look at all these various results from Burberry in one chart and then we can move on to our final task, which is to measure a company's overall growth rate:
4) Measure the company's average growth rate across tangible capital employed, revenues and dividends
We could just leave it there and have three separate figures for growth. But I'd rather have a single figure and averaging the growth rate from tangible capital employed, revenues and dividends seems like a sensible idea.
This will give us a final Growth Rate figure:
Growth Rate = (Tangible capital employed per share growth rate + revenue per share growth rate + dividend per share growth rate) / 3
For Burberry this gives us a final Growth Rate figure of:
Burberry's Growth Rate = (10.8% + 10.3% + 14.3%) / 3 = 11.8%
A near-12% growth rate is well above average, although whether Burberry can maintain such growth in the years ahead is a question for another day.
One small step towards a reasonably detailed analysis
This Growth Rate figure is not a magic bullet. In fact, it's only one part of an even remotely detailed analysis.
But it's a start, and from the research I've done I think it does a pretty decent job of estimating a company's underlying growth rate, i.e. growth in its ability to generate earnings, cash and dividends under normal conditions.
From Growth Rate to Growth Quality
In the next installment of this series, I'll cover Growth Quality, which attempts to measure the consistency of a company's dividend growth, as well as some factors (including free cash flow) which are likely to either enable or undermine sustainable dividend growth.