### An Introduction to Defensive Value Investing

**Week 2: Growth Rate**

“The stock of a growing company, if purchasable at a suitable price, is obviously preferable to others.”

Benjamin Graham

Last week we focused on companies with consistent histories of profits and dividends. That’s a reasonable starting point, but there are many more things we need to consider, one of which is growth.

Thanks to inflation, unless a company can grow its earnings and dividends over time then in real terms the value of its economic output will fall. So in addition to consistent profits and dividend payments, I always look for consistent growth.

Growth can be broken down into growth rate and growth quality, and this week we’ll focus on growth rate.

## Measuring Growth Rate

Benjamin Graham said a growing company is preferable to others, which seems obvious enough. I would go one step further and say that a high-growth company is preferable to a low-growth company, as long as that growth is sustainable.

To differentiate between corporate hares and tortoises I use a measure of growth which is:

**Broadly based**, reflecting the company’s overall growth as much as possible**Long-term**, measuring growth over a decade rather than a year or two

### Long-term capital, revenue and dividend growth

I measure a company’s growth rate across capital employed, revenues and dividends. Capital employed and revenues are new terms, so here are some definitions:

Definitions

**Capital employed: **Companies need assets, such as factories, machinery and stock in order to produce products, services and profits. These assets are paid for with a mix of long and short-term funds, and capital employed is the name given to long-term funds. There are three primary forms of capital: Equity capital, debt capital and leased capital.

If someone else calculates capital employed for you (e.g. a data provider such as SharePad or Morningstar) check to see whether it includes leased capital (i.e. lease liabilities) or not. When leases are included it is sometimes called lease-adjusted capital employed, but I’ll just refer to it as capital employed.

**Equity capital:** This belongs to shareholders and is made up of retained earnings (i.e. earnings which are not paid out as dividends) and money raised directly from shareholders, typically through a rights issue (where shareholders inject additional funds into a company in exchange for new shares). Also known as shareholder equity, net asset value (because it’s equal to total assets net of – i.e. minus – all non-shareholder liabilities) and book value. It is recorded on the balance sheet.

**Debt capital:** This is commonly known as borrowings and is the sum of both current (short-term) and non-current (long-term) interest-bearing debts, typically owed to banks and other lenders. It is recorded on the balance sheet.

**Leased capital: **This is another form of debt capital where the lender is a landlord or other leasor. Think of a shop which is leased rather than purchased. The retailer has what is known as a right of use asset, i.e. the right to use the shop for a certain period of time, and it also has a liability, i.e. an obligation to pay rent to the landlord for a certain period of time. From 2019 onwards this is recorded on the balance sheet, but prior to that is recorded only in the notes at the back of the annual report.

**Revenues: **Also known as sales or turnover, this is the total amount of money earned by the company over a given period (typically six months or a year), before any expenses are deducted. You’ll find it at the top of the income statement.

I measure capital employed growth because capital employed is the foundation of all corporate activity and future returns. Without capital to fund assets such as factories, vehicles, machinery, computers and so on, companies cannot provide products and services, and without products and services they cannot generate revenues. And if a company’s assets and capital employed aren’t growing, then any revenue growth is unlikely to be sustainable.

Revenue growth is second only to capital growth in terms of importance, because without long-term revenue growth, earnings and dividend growth cannot be sustainable. It’s true that in the short-term earnings can increase without revenue growth, but that requires wider profit margins (the ratio of earnings to revenues), and profit margins can only widen so far.

After revenue growth it seems logical to look at earnings growth. After all, the price of a company is simply the present value of its future earnings, and earnings are ultimately the source of all dividends.

However, in my experience it’s difficult to measure earnings growth because they’re so volatile. If a company’s earnings go up/down by 20%, does that mean it’s grown/shrunk, or has it just had a good/bad year?

So I don’t measure earnings growth directly, although I do measure it indirectly when I measure growth quality and profitability (which I’ll cover in a later week).

Instead of earnings growth, I measure dividend growth. I do this partly because I’m a dividend-focused investor and I’m looking for companies that can growth their income ahead of inflation, but also because dividends are typically much more stable than earnings and dividend growth is usually (although not always) more closely related to the fundamental growth of the company.

To make life simple, I combine the growth rates of these various factors into a single metric which I somewhat unimaginatively call **Growth Rate**.

### Calculating Growth Rate

Financial results are volatile, even for the most defensive of companies. A company can see its revenues increase by 10% one year and decrease by 15% the next year. This makes it hard to say whether a company is growing or not in any meaningful sense.

To get around this problem we can use an approach borrowed from Benjamin Graham. The basic idea is to average capital, revenue or dividends across several years in order to reduce the ups and downs of any one year. We can then measure the growth rate between these average values several years ago and their values today.

More specifically, we’ll start with ten years of data for capital, revenues and dividends. Then we’ll calculate average values for the oldest three years in that period. Then we’ll calculate average values for the newest three years. After that, we’ll calculate the growth rate between those old and new averages.

So the first thing we’ll need is capital employed, revenue and dividend data, all on a per share basis for the last ten years.

You should already have the dividend data if you worked through the profitable dividends calculations for a company last week.

You’ll find revenues at the top of the income statement. For capital employed you’ll need to find figures for borrowings (current and non-current), total equity and lease liabilities, all of which are on the balance sheet (except pre-2019 lease liabilities, which will be in the notes at the back of the accounts. Search for “operating lease”).

You’ll also need the number of shares to turn those into per share figures, which you can find in the notes at the back of the annual report. It’s usually called diluted weighted average number of shares, or something similar.

As an example of how to convert a total figure into a per share figure, here’s the calculation for capital employed (converts from pounds into pence per share):

capital employed per share = (total equity + total borrowings + lease liabilities) / average number of shares * 100

In most cases, FTSE 350 companies record their results in millions of pounds, so you’ll have to round the number of shares accordingly.

This is of course much easier if you use an investment spreadsheet.

The steps for calculating Growth Rate are as follows:

Steps to calculate Growth Rate

**1) Calculate revenue per share (RPS) growth**:

1.1) Calculate average RPS for the oldest three-year period

1.2) Calculate average RPS for the latest three-year period

1.3) Calculate RPS growth:

*RPS growth = (new average RPS / old average RPS) – 1 × 100%*

**2) Repeat step 1 for capital employed per share (CEPS)**

**3) Repeat step 1 for dividends per share (DPS)**

**4) Calculate total growth as the average of RPS, CEPS and DPS growth:**

*total growth = (RPS growth + CEPS growth + DPS growth) / 3*

**5) Calculate the annualised growth rate:**

*Growth Rate = ((100% + total growth) ^ 1/ 7) – 100%*

In the expression above, “^” is called a caret and it represents an exponential, in other words it means “raise to the power”. In this case we’re raising the total growth to the 1/7th power, which is the opposite of raising it to the seventh power.

*Why do we do that?*

Imagine if we started with the annual growth rate and wanted to know what total growth that growth rate would produce over seven years. To do that we’d add 100% to the annual growth rate and then raise the result to the seventh power (i.e. times it by itself seven times).

To calculate Growth Rate, we’re starting with the total growth over seven years (there are seven years between the old and new three-year average periods) and we want to know the annual growth rate required to produce that total growth. So we’re doing the opposite calculation, and the opposite of raising a number to the 7th power is to raise it to the 1/7th power.

This sounds more complicated than it actually is, and an investment spreadsheet can do this calculation in an instant.

But rather than get bogged down in theory, I think an example is the best way to show how this all works. But first, here are my Growth Rate rules of thumb:

Growth Rate rules of thumb

Only invest in a company if its revenue, capital employed and dividend per share growth rates are above inflation (approximately 2%) over the last ten years.

Only invest in a company if its overall Growth Rate is above inflation (approximately 2%).

*Let’s see how this works in the real world.*

### Burberry’s Growth Rate

I’ll use Burberry as an example again. If you look back at Table 1.2 from last week you’ll see that Burberry’s 2009 EPS were negative. This highlights one of the problems with measuring earnings growth, which is why I don’t even try (at least directly).

Table 2.1 contains all the data we’ll need to calculate Burberry’s Growth Rate.

Year | Revenue PS (p) | Capital Employed PS (p) | Dividends PS (p) |
---|---|---|---|

2010 | 268.2 | 287.5 | 14.0 |

2011 | 338.1 | 319.1 | 20.0 |

2012 | 418.0 | 386.2 | 25.0 |

2013 | 447.6 | 404.9 | 29.0 |

2014 | 520.9 | 464.7 | 32.0 |

2015 | 563.5 | 546.9 | 35.2 |

2016 | 563.7 | 554.2 | 37.0 |

2017 | 625.5 | 596.3 | 38.9 |

2018 | 636.4 | 522.5 | 41.3 |

2019 | 655.3 | 586.2 | 42.5 |

**Table 2.1: Burberry’s Growth Rate data to 2019**

You can get a sense of how fast Burberry has grown by looking at its 2019 revenues, capital employed and dividends per share compared with the values from 2010. All of them have more than doubled in that time, so the company has definitely grown quite quickly.

However, it will be much easier to compare Burberry’s growth to other companies if the mass of figures in Table 2.2 is first converted into a single Growth Rate value using the steps below:

Calculating Burberry’s Growth Rate

**1) Calculate revenue per share (RPS) growth:**

1.1) Calculate average RPS for the old three-year period:

RPS for 2009, 2010 and 2011 was 271.3, 274.8 and 339.7 pence respectively, so:

*old average RPS = (271.3 + 274.8 + 339.7) / 3 = 295.3 pence*

1.2) Calculate average RPS for the new three-year period:

RPS for 2016, 2017 and 2018 was 561.6, 620.0 and 636.4 pence respectively, so:

*new average RPS = (561.6 + 620.0 + 636.4) / 3 = 606.0 pence*

1.3) Calculate RPS growth:

*RPS growth = (606.0 / 295.3) – 1 = 1.052 = 105.2%*

**2) Calculate capital employed per share (CEPS) growth:**

2.1) Calculate average CEPS for old three-year period:

CEPS for 2009, 2010 and 2011 was 177.1, 184.7 and 199.6 pence respectively, so:

*old average CEPS = (177.1 + 184.7 + 199.6) / 3 = 187.1p*

2.2) Calculate average CEPS for new three-year period:

CEPS for 2016, 2017 and 2018 was 361.0, 387.1 and 336.2 pence respectively, so:

*new average CEPS = (361.0 + 387.1 + 336.2) / 3 = 361.4p*

2.3) Calculate CEPS growth:

*CEPS growth = (361.4 / 187.1) – 1 = 0.932 = 93.2%*

**3) Calculate dividend per share (DPS) growth:**

3.1) Calculate average DPS for old three-year period:

DPS for 2009, 2010 and 2011 was 12.0, 14.0 and 20.0 pence respectively, so:

*old average DPS = (12.0 + 14.0 + 20.0) / 3 = 15.3p*

3.2) Calculate average DPS for new three-year period:

DPS for 2016, 2017 and 2018 was 37.0, 38.9 and 41.3 pence respectively, so:

*new average DPS = (37.0 + 38.9 + 41.3) / 3 = 39.0p*

3.3) Calculate DPS growth:

*DPS growth = (39.0 / 15.3) – 1 = 1.548 = 154.8%*

**4) Calculate total growth as the average of RPS, CEPS and DPS growth:**

total *growth = (105.2% + 93.2% + 154.8%) / 3 = 117.7%*

**5) Calculate Growth Rate:**

*Growth Rate = ((100% + 117.7%) ^ 1/7) – 100% = 11.8% *

Burberry’s Growth Rate of 11.8% per year is well above my 2% rule of thumb minimum and well above inflation for the period as well.

Burberry’s revenue, capital employed and dividends per share have all grown by around 100% or more over the last decade, so its impressive growth has been both rapid and broad-based.

Here’s a quick recap of the Growth Rate rule of thumb:

Growth Rate rule of thumb:

Only invest in a company if its revenue, capital employed and dividend per share growth rates are above inflation (approximately 2%) over the last ten years.

Only invest in a company if its overall Growth Rate is above inflation (approximately 2%).

## Next week

Growth is good, but consistent, sustainable growth is better, and next week we’ll look at how to measure the consistency and sustainability of a company’s growth.