Among all the companies that exist on the London Stock Exchange, only a few can grow their revenues, earnings and dividends consistently for years on end, and they’re the ones I like to focus on.
But I haven’t said anything about how fast those companies are growing and – assuming it’s sustainable – faster growth is better than slower growth.
For passive investors, growth of earnings and dividends isn’t usually a problem. An investor who buys the FTSE 100 will usually get earnings and dividend growth of 2-3% above inflation.
However, what’s true of the stock market in aggregate isn’t true of every company within it. When you’re picking individual companies to invest in you should think about whether they’re likely to grow fast enough to make your investment research worthwhile.
There are many companies that struggle to grow at all, let alone the inflation plus 2-3% a year required keep up with the overall market. What’s needed is a way to measure how quickly a company is growing so that it’s possible to differentiate between the hares and the tortoises.
Given what I’ve said before about being a long-term investor, you won’t be surprised to hear that I measure a company’s growth rate over the past decade. I think that’s much more sensible than just looking at its growth over the last year (or even the last three).
Which growth to measure
In practice growth turns out to be difficult to define. There are so many different aspects of a company that can grow, and a myriad of things that can be measured.
In most cases when investors talk about growth they mean earnings growth, but that only provides a restricted view of the company. I like to take a simple but comprehensive approach, so I measure growth across each of the three key factors that I’ve concentrated on before, which are revenues, earnings and dividends.
It’s important to measure all three because if you just measure one of them you’re only getting part of the picture (rather like feeling the trunk of an elephant in the dark and thinking it’s a snake). For example:
- If dividends are going up but earnings are going nowhere then eventually the dividend will become unsustainable.
- If earnings and dividends are going up but revenues are not increasing then it must be margins that are going up, and margins can only go up so far.
- If revenues are going up but profits and dividends are not, then the company is selling more but failing to convert sales growth into anything that can be returned to shareholders.
So all three factors of revenues, earnings and dividends need to be increasing consistently over time; only then is a company truly increasing its value on a sustainable basis.
How to measure growth
My thoughts on how to measure long-term growth come originally from Ben Graham. His idea was to measure growth over a 10 year period and to measure it in a robust fashion, trying not to be excessively influenced by the ups and downs of any single year.
Graham’s approach was simple:
Measure growth between two separate three year periods; one at the start of the last decade and one at the end of it.
In other words:
Measure growth between the average earnings from 10, 9 and 8 years ago with the average earnings of from 3, 2 and 1 year ago (with 1 year ago being the most recent set of accounts).
This provides a simple and yet relatively robust way to measure the company’s growth rate across at least one business cycle. It’s robust in two ways:
- It measures growth over a long period of time rather than just a year or three.
- It compares two separate three year periods which helps to reduce the influence of any single year.
Of course this approach isn’t perfect. There are many factors which can affect how fast a company has grown, from industry cycles to credit cycles, as well as other things so numerous it would take a hundred years just to list them.
The truth is that there is no perfect way to measure growth, and even if there was, past growth is definitely not a perfect predictor of future growth.
Having said that, there is little else to go on other than the past because the future is obscured by a thick fog. Graham’s approach is as good as anything else I’ve seen, and that’s why I’ve been using it for several years now.
This metric can easily be applied to each of revenues, adjusted earnings and dividends. By measuring growth over the long-term for all three you can build up a pretty good picture of how the company has done over that time period.
Accurate measurements cannot produce accurate predictions
I want to really hammer this point home. These measurements of past growth are not used to make future predictions.
While it’s true that several research studies – and to some extent, common sense – tell us that companies with long histories of high and consistent growth rates in the past are more likely to produce high and consistent growth in the future, an accurate future prediction is not possible. It would be nice if it was, but it isn’t.
The problem with predictions is that there are just so many unknown variables, so much uncertainty, that any attempt to accurately predict the future is largely a waste of time.
Instead, what I’m trying to do by measuring the rate and quality of a company’s growth in the past is to simply weigh the odds of success in my favour.
I don’t need to estimate Tesco’s future growth rate to the third decimal place; I simply need to know that companies with long and consistent records of rapid, sustainable growth are more likely than average to grow more quickly and more consistently than average in future.
On the other hand, companies that have slow and inconsistent growth are less likely than average to grow quickly or consistently in future.
Personally I much prefer to buy an outstanding business at a fair price rather than a fair business at an outstanding price (although depending on the opportunity set I’ll take either). As Charlie Munger once said, “Investing is where you find a few great companies and then sit on your ass”.