Last Updated June 4, 2021
This article outlines how I look for quality companies capable of producing consistent and sustainable growth over long periods of time.
Table of Contents
- The importance of consistent and sustainable growth
- Quality companies produce consistent growth
- Quality companies produce sustainable growth
- A reasonable definition of sustainable growth
- Burberry’s growth sustainability
- Calculating Growth Quality
The importance of consistent and sustainable growth
Those traits are a good place to start, but the consistency and sustainability of a company’s growth are just as important.
For example, a company may have doubled its dividend over the last decade whilst maintaining a healthy degree of dividend cover, but what if that growth came in a single year as a result of a single large acquisition?
Is that growth sustainable? In other words, is the company likely to pull off an equally successful acquisition in the next decade? Perhaps, but then again, perhaps not.
Perhaps the company got lucky with that deal. Perhaps there are no other acquisition targets of similar size. Perhaps the acquisition will lead to problems down the road as management become distracted by the long and complex process of integrating such a large acquisition.
In most cases it will be impossible to know if growth driven by a one-off “big bang” event will be repeatable. And so, if we’re looking for companies that can consistently grow their value (their revenues, earnings and dividends) over a long period of time, then we need to look for “quality growth” companies, i.e. companies capable of producing consistent, sustainable growth over long periods of time.
Consistent growth happens year after year, although not necessarily every year. Consistent growth over ten or twenty years is more likely to be driven by an enduring competitive strength than by an extraordinary stroke of luck.
Sustainable growth is growth which could, in theory, go on for decades rather than just a handful of years. For example, a company could grow its dividend for a decade while seeing its earnings decline, but in the long-run that will lead to an uncovered and unsustainable dividend.
Quality companies produce consistent growth
I have a simple method for measuring the consistency of a company’s growth. I just count how often a handful of key financial factors went up on a per share basis over the last decade.
These key financial factors are (in order of importance):
- Capital employed: This is the sum of fixed capital (e.g. factories or machinery) and working capital (e.g. stock, cash or raw materials). These are assets which have been funded by shareholders, lenders and landlords.
- Revenues: The total amount paid into the business by customers in exchange for products and services.
- Earnings: The amount left over after all expenses have been deducted from revenues.
- Dividends: Excess cash which is returned to shareholders when it cannot be reinvested within the company at acceptable rates of return.
In simple terms then, consistent and sustainable growth occurs when a company employs more productive assets (capital employed) to produce more goods and services which customers pay more for (revenues). If costs are kept under control then more revenues leads to more profits (earnings) and that will eventually allow more dividends to be paid to shareholders.
Here’s the calculation:
Calculating growth consistency
The division by 36 is there because the maximum number of annual increases in a ten-year period is nine, and with four factors that gives a maximum possible score of 36, so dividing by 36 gives us the growth consistency score as a percentage.
This calculation is done automatically if you use my investment spreadsheet, which you can find on the free resources page.
As with most things, I have rules of thumb to help me filter out companies with relatively inconsistent growth:
Rules of thumb for growth consistency
This is a rule of thumb rather than a hard rule, so it requires some judgement.
For example, a company may have seen its capital employed decline for several years in a row because it was divesting capital intensive low quality business units. As a result, the company’s profitability (return on capital employed, which I’ll cover in a later article) has increased in recent years.
In most cases I’d say that decline in capital employed was a good thing, as high return capital-light businesses are often easier to grow than low return capital-intensive businesses. So remember to use judgement as well as cold hard numbers when you’re analysing a company.
Here’s a quick real-world example of growth consistency.
Ted Baker’s growth consistency
Ted Baker is a global fashion retailer which I purchased in 2018, partly because the company produced consistently covered dividends and robust dividend growth over the previous decade. Here are the relevant numbers to 2019 (i.e. just before the pandemic):
Ted Baker’s capital employed, revenues, earnings and dividends to 2019
If you look at Ted Baker’s 2019 results compared to its 2010 results, it’s obvious the company grew substantially over those ten years. The chart also gives the impression that Ted grew consistently, but how consistently?
Let’s find out.
Calculating Ted Baker’s growth consistency
We can now see, with hard numbers, how consistent Ted Baker’s growth really was. From 2010 to 2019, it grew its per share capital employed, revenues, earnings and dividends almost every year, or 89% of the time to be precise.
As a result, Ted Baker easily passed my growth consistency rules in 2019.
But consistent growth alone is not enough. Sustainable growth is even more important, so that’s what we’ll look at next.
Quality companies produce sustainable growth
While consistent growth is nice, it’s worthless to long-term investors unless it can be sustained for many years into the future. This is how I think about growth sustainability:
- For dividend growth to be sustainable over the long-term it must be driven by earnings growth, otherwise the dividend will eventually exceed the company’s earnings, leaving the dividend uncovered and unsustainable.
- For earnings growth to be sustainable over the long-term it must be driven by revenue growth, otherwise profit margins must continually expand and profit margins cannot expand forever.
- For revenue growth to be sustainable over the long-term it must be driven by capital employed growth, otherwise return on capital must continually increase, and return on capital cannot increase forever.
This is why I begin my search for sustainable dividend growth by looking for sustainable capital employed growth.
Sustainable dividend growth is driven by sustainable capital employed growth
In most cases capital employed is funded primarily by equity capital (shareholder equity), debt capital (borrowings) and leased capital (lease liabilities), and these differ in terms of their sustainability.
The quick and easy way for a company to employ more capital is to take on more debt or leases. Just sign up for a new bank loan or rental agreement and – hey presto – the company has access to another factory filled with shiny new machines.
However, growing capital employed primarily by increasing debts and leases is not likely to be sustainable over the long-term.
That’s because debts and leases come with relatively fixed costs in the form of interest or rent payments. If earnings fall during a recession then a highly leveraged company (one using large amounts of debts or leases as a lever to boost returns) can quickly find itself struggling to make interest or rent payments.
A more sustainable way to grow capital employed is by employing more equity capital. Equity capital is typically low risk because there are no fixed repayment terms and dividends are optional, so if a company funded only by equity capital goes into a downturn it can simply cut or suspend the dividend if that’s in the best interests of the company.
Equity capital can be raised from two main sources:
1) Rights issues: This is where management ask shareholders to inject additional funds into the company in exchange for newly issued shares.
Rights issues are often used to fund long-term investments where the expected returns are relatively uncertain. A good example would be a rights issue used to fund a major acquisition. This can be sensible because it matches uncertain returns from the acquired business with a funding source that has almost infinitely flexible repayment terms (again, dividends are optional and equity capital never has to be repaid).
However, large acquisitions are risky and in many cases the task of integrating an acquired business can be distracting and expensive, leading to problems which more than outweigh the perceived benefits of the deal.
So as a general rule I’m not a fan of companies that raise significant amounts of equity through rights issues. However, in some cases a large rights issue is acceptable, such as a rights issue to pay up front for a long-term license or supply agreement. As always, the details matter.
2) Retained earnings: A more sustainable way to raise additional equity funding is to simply retain earnings within the business rather than paying them out to shareholders as a dividend. These retained earnings still belong to shareholders, so they end up on the balance sheet as shareholder equity.
Retained earnings tend to be small relative to the size of the company’s operations, so they’re much easier to deploy on a regular basis.
For example, a competitive company might produce annual earnings which are about 10% of its capital employed (known as net return on capital employed). If the company pays out half of those earnings and retains the other half, it will be incrementally adding equity capital equal to about 5% of its capital base each year. 5% isn’t a huge amount, and most good management teams can easily find productive ways to invest those additional funds.
To put it another way, if equity raised from a major rights issue is like an oversized Christmas dinner, then equity raised from retained earnings is like the bar of chocolate you have with lunch every day. Both will make you grow, but one will probably give you indigestion while the other is a much more sustainable and ultimately successful route to growth (if a growing waistline is what you’re after).
In summary then, sustainable dividend growth is driven by sustainable capital employed growth, and sustainable capital employed growth is usually driven by retained earnings rather than rights issues, debts or leases.
Since growth funded by those external sources tends to be less sustainable, it would be useful to know how much external funding a company has used to drive growth and how that compares to the company’s ability to afford and absorb that funding.
Measuring external growth funding
One way to discover how much external growth funding has been used is to start by measuring the total increase in capital employed on a per share basis (CEPS) over the last ten years:
CEPS increase = CEPS today - CEPS 10 years ago
We’re interested in growth capital raised from external sources, so we need to deduct total retained earnings per share:
total retained EPS = 9yr total EPS - 9yr total DPS
external growth funding = CEPS increase - total retained EPS
I should mention that calculating retained earnings by subtracting dividends per share from earnings per share is slightly inaccurate because reported dividends per share are, for various reasons, usually not quite the same as the actual dividend paid to shareholders during the year. However, any differences are usually small in the context of what we’re looking at here, especially if you include special dividends in the calculation.
We can now compare the amount of external growth funding used over a ten year period to the amount the company earned over those ten years. This tells us something about the magnitude of the external growth funding used and the company’s ability to absorb and afford that funding.
Here’s the calculation in full:
Calculating the external growth funding ratio
Note that nine-year figures for EPS and DPS are used in the calculation as EPS and DPS ten years ago did not contribute to capital employed growth in the last ten years (it contributed to growth from year eleven to year ten, but not after year ten and that’s the period we’re looking at).
Let’s see this in action with Ted Baker.
Ted Baker’s external growth funding ratio
To calculate Ted Baker’s external growth funding ratio we’ll need its per share earnings, dividends and capital employed for a ten-year period, all of which we already have in the table above.
Calculating Ted Baker’s external growth funding ratio
The calculation above shows that from 2010 to 2019, Ted Baker drove its growth by raising and deploying external funds (mostly debts and leases) equivalent to more than 98% of its total earnings over that period.
This shows up on the company’s balance sheet. For example, over that ten-year period Ted’s debts went from zero to £139 million while its lease liabilities went from £114 million to £260 million. The number of shares also increased by about 10%, which means some of the external funding came from issuing new shares.
The chart shows that most of Ted Baker’s capital employed was made up of higher risk debts and leases rather than lower risk equity.
So we now know that Ted Baker used external funding to increase its growth rate, but how much external funding is too much?
A reasonable definition of sustainable growth
In Ted Baker’s case, using external growth funding equal to almost 100% of its earnings over a ten-year period was almost certainly too much.
In late 2019 and early 2020, Ted surprised shareholders (of which I was one) with a string of profit warnings, a dividend cut and then a full dividend suspension. And this was before the impact of COVID-19.
Tough trading conditions were blamed, but after reviewing the situation in some detail, I think the company’s use of external funds to drive rapid growth was the underlying cause of the company’s problems.
Rapid growth requires lots of new stores, new staff, new supply chain partners, new customers, new processes, new management and so on, all of which have to go through a long and expensive experience curve before they can operate anywhere near optimally. Combine all that newness and inexperience with rapidly increasing debt and lease obligations and it’s no wonder Ted Baker eventually ran into serious problems.
To use a driving analogy, turbocharging growth with external funding is like driving a car too fast. It doesn’t matter how safe the car when it’s standing still. Even the sturdiest Volvo will crash and burn if it’s being driven too fast down a twisty road late at night.
In reality, some use of external funding from debts and leases is fine, but it has to be used with caution. I know this from experience, because over the last ten years I have invested in two high growth companies which subsequently crashed and then required lengthy, expensive repairs.
In both cases their external growth funding came to more than 100% of their ten-year earnings. In one case (Chemring) acquisition-driven growth was fuelled by rights issues and debts, the other (Ted Baker) used rapidly increasing debt and lease liabilities to fund a massive increase in stores and inventory.
In my experience then, an external growth funding ratio of 100% or more is very likely to cause operational problems at some point. The truth is that most companies simply cannot absorb and deploy that amount of external capital without producing cracks that eventually cause the company to crumble.
In other words:
- If the external growth funding ratio is zero then the company’s growth is likely to be sustainable (although far from guaranteed).
- If the external growth funding ratio is 100% or more then the company’s growth is unlikely to be sustainable and could instead be a sign of high risks and reckless management.
That’s great, but I would prefer it if zero was bad and 100% was good, so the last thing I do is switch that around and give the resulting percentage a better name:
Calculating growth sustainability
For Ted Baker that would give a growth sustainability score of 1.7%, which better highlights just how risky and ultimately unsustainable that company’s rapid growth really was.
Although a growth sustainability score of 100% is very good, indicating that the company’s growth either was or could have been funded entirely from retained earnings, a lower score isn’t necessarily unacceptable.
There’s a continuum of risk and sustainability between a score of zero percent and 100%, and exactly what constitutes an unacceptably low score will vary from one company to the next.
However, as a starting point, here’s my rule of thumb for growth sustainability:
Rule of thumb for growth sustainability
Here’s one more quick example, this time looking at another company I bought a few years ago. It’s somewhat similar to Ted Baker but with much more sustainable growth.
Burberry’s growth sustainability
Like Ted Baker, Burberry is a fashion retailer, although one that exists a few steps higher up the luxury fashion ladder.
Like Ted Baker, Burberry has also produced impressively rapid and consistent growth over the decade to 2019, with a ten-year Growth Rate of 9.5% and a growth consistency score of 89%.
The foundation of this growth was the company’s capital employed, consisting of stores, offices, warehouses and stock, along with many other essential assets. The value of Burberry’s capital employed increased from £1,271 million in 2010 to £2,433 million in 2019, an increase of £1,162 million. But was that growth sustainably driven by retained earnings or was it made up mostly of an increasing debts and lease liabilities?
Let’s find out.
Calculating Burberry’s growth consistency
With a growth sustainability score of almost 100%, Burberry needed very little in the way of external growth funding over that ten year period.
Yes, its lease liabilities did increase as it opened new stores, but it also paid down a lot of debt, going from over £200 million of debt in 2010 to almost nothing in 2019. Meanwhile, the value of shareholder equity went from £590 million to almost £1.5 billion, far outpacing the relatively small increase in external funds.
As the chart shows, low risk equity made up the bulk of Burberry’s capital employed, making up an ever-larger portion of the company’s capital base compared to higher risk debts and leases.
So now we’ve looked at growth consistency and a couple of examples showing sustainable and unsustainable growth. The last step is to combine consistency and sustainability into a single Growth Quality metric.
Calculating Growth Quality
The calculation for Growth Quality is incredibly simple; it’s just the average of growth consistency and growth sustainability:
Calculating Growth Quality
Here’s the calculation for Ted Baker:
Ted Baker’s Growth Quality
As you can see, Ted Baker has a high score for growth consistency but a terrible score for growth sustainability, leaving its Growth Quality score very much in mediocre territory.
Once again I have an associated rule of thumb which should rule out the majority of companies where growth isn’t sufficiently consistent or sustainable:
Rule of thumb for Growth Quality
If you want to have a go at using these metrics then take a look at my spreadsheet, which you’ll find on the free resources page.
And last but not least, here’s a summary of the various rules of thumb which I use for growth consistency, growth sustainability and growth quality:
Rules of thumb for growth consistency, sustainability and quality
Remember: These are rules of thumb and they don’t have to be applied strictly. Use them as a way to highlight potential problems which may require deeper analysis.