Estimating Growth - PDF

ESTIMATING GROWTH © All Slides | Aswath Damodaran GROWTH CAN BE GOOD, BAD OR NEUTRAL… © All Slides | Aswath Damodaran  THE VALUE OF GROWTH 3 q When valuing a company, it is easy to get caught up in the details of estimating growth and start viewing growth as a “...

ESTIMATING GROWTH © All Slides | Aswath Damodaran GROWTH CAN BE GOOD, BAD OR NEUTRAL… © All Slides | Aswath Damodaran  THE VALUE OF GROWTH 3 q When valuing a company, it is easy to get caught up in the details of estimating growth and start viewing growth as a “good”, i.e., that higher growth translates into higher value. q Growth, though, is a double-edged sword. q The good side of growth is that it pushes up revenues and operating income, perhaps at different rates (depending on how margins evolve over time). q The bad side of growth is that you have to set aside money to reinvest to create that growth. q The net effect of growth is whether the good outweighs the bad. © All Slides | Aswath Damodaran  WAYS OF ESTIMATING GROWTH IN EARNINGS 4 q Look at the past q The historical growth in earnings per share is usually a good starting point for growth estimation q Look at what others are estimating q Analysts estimate growth in earnings per share for many firms. It is useful to know what their estimates are. q Look at fundamentals q With stable margins, operating income growth can be tied to how much a firm reinvests, and the returns it earns. q With changing margins, you have to start with revenue growth, forecast margins and estimate reinvestment. © All Slides | Aswath Damodaran HISTORICAL GROWTH © All Slides | Aswath Damodaran  HISTORICAL GROWTH 6 q Historical growth rates can be estimated in a number of different ways q Arithmetic versus Geometric Averages q Simple versus Regression Models q Historical growth rates can be sensitive to q The period used in the estimation (starting and ending points) q The metric that the growth is estimated in.. q In using historical growth rates, you have to wrestle with the following: q How to deal with negative earnings q The effects of scaling up © All Slides | Aswath Damodaran  MOTOROLA: ARITHMETIC VS GEOMETRIC GROWTH RATES 7 © All Slides | Aswath Damodaran  A TEST 8 q You are trying to estimate the growth rate in earnings per share at Time Warner from 1996 to 1997. In 1996, the earnings per share was a deficit of $0.05. In 1997, the expected earnings per share is $ 0.25. What is the growth rate? q -600% q +600% q +120% q Cannot be estimated © All Slides | Aswath Damodaran DEALING WITH NEGATIVE EARNINGS q When the earnings in the starting period are negative, the growth rate cannot be estimated. (0.30/-0.05 = -600%) q There are three solutions: q Use the higher of the two numbers as the denominator (0.30/0.25 = 120%) q Use the absolute value of earnings in the starting period as the denominator (0.30/0.05=600%) q Use a linear regression model and divide the coefficient by the average earnings. q When earnings are negative, the growth rate is meaningless. Thus, while the growth rate can be estimated, it does not tell you much about the future. © All Slides | Aswath Damodaran  THE EFFECT OF SIZE ON GROWTH: CALLAWAY GOLF 10 Year Net Profit Growth Rate 1990 1.80 1991 6.40 255.56% 1992 19.30 201.56% 1993 41.20 113.47% 1994 78.00 89.32% 1995 97.70 25.26% 1996 122.30 25.18% q Geometric Average Growth Rate = 102% © All Slides | Aswath Damodaran EXTRAPOLATION AND ITS DANGERS Year Net Profit 1996 $ 122.30 1997 $ 247.05 1998 $ 499.03 1999 $ 1,008.05 2000 $ 2,036.25 2001 $ 4,113.23 q If net profit continues to grow at the same rate as it has in the past 6 years, the expected net income in 5 years will be $ 4.113 billion. © All Slides | Aswath Damodaran ANALYST ESTIMATES © All Slides | Aswath Damodaran ANALYST FORECASTS OF GROWTH q While the job of an analyst is to find under and over valued stocks in the sectors that they follow, a significant proportion of an analyst’s time (outside of selling) is spent forecasting earnings per share. q Most of this time, in turn, is spent forecasting earnings per share in the next earnings report q While many analysts forecast expected growth in earnings per share over the next 5 years, the analysis and information (generally) that goes into this estimate is far more limited. q Analyst forecasts of earnings per share and expected growth are widely disseminated by services such as Zacks and IBES, at least for U.S companies. © All Slides | Aswath Damodaran  HOW GOOD ARE ANALYSTS AT FORECASTING GROWTH? 14 q Analysts forecasts of EPS tend to be closer to the actual EPS than simple time series models, but the differences tend to be small Study Group tested Analyst Time Series Error Model Error Collins & Hopwood Value Line Forecasts 31.7% 34.1% Brown & Rozeff Value Line Forecasts 28.4% 32.2% Fried & Givoly Earnings Forecaster 16.4% 19.8% q The advantage that analysts have over time series models q tends to decrease with the forecast period (next quarter versus 5 years) q tends to be greater for larger firms than for smaller firms q tends to be greater at the industry level than at the company level q Forecasts of growth (and revisions thereof) tend to be highly correlated across analysts. © All Slides | Aswath Damodaran  ARE SOME ANALYSTS MORE EQUAL THAN OTHERS? 15 q A study of All-America Analysts (chosen by Institutional Investor) found that q There is no evidence that analysts who are chosen for the All-America Analyst team were chosen because they were better forecasters of earnings. (Their median forecast error in the quarter prior to being chosen was 30%; the median forecast error of other analysts was 28%) q However, in the calendar year following being chosen as All-America analysts, these analysts become slightly better forecasters than their less fortunate brethren. (The median forecast error for All-America analysts is 2% lower than the median forecast error for other analysts) q Earnings revisions made by All-America analysts tend to have a much greater impact on the stock price than revisions from other analysts q The recommendations made by the All America analysts have a greater impact on stock prices (3% on buys; 4.7% on sells). For these recommendations the price changes are sustained, and they continue to rise in the following period (2.4% for buys; 13.8% for the sells). © All Slides | Aswath Damodaran  THE FIVE DEADLY SINS OF AN ANALYST 16 q Tunnel Vision: Becoming so focused on the sector and valuations within the sector that you lose sight of the bigger picture. q Lemmingitis: Strong urge felt to change recommendations & revise earnings estimates when other analysts do the same. q Stockholm Syndrome: Refers to analysts who start identifying with the managers of the firms that they are supposed to follow. q Factophobia (generally is coupled with delusions of being a famous story teller): Tendency to base a recommendation on a “story” coupled with a refusal to face the facts. q Dr. Jekyll/Mr.Hyde: Analyst who thinks his primary job is to bring in investment banking business to the firm. © All Slides | Aswath Damodaran  PROPOSITIONS ABOUT ANALYST GROWTH RATES 17 q Proposition 1: There if far less private information and far more public information in most analyst forecasts than is generally claimed. q Proposition 2: The biggest source of private information for analysts remains the company itself which might explain q why there are more buy recommendations than sell recommendations (information bias and the need to preserve sources) q why there is such a high correlation across analysts forecasts and revisions q why All-America analysts become better forecasters than other analysts after they are chosen to be part of the team. q Proposition 3: There is value to knowing what analysts are forecasting as earnings growth for a firm. There is, however, danger when they agree too much (lemmingitis) and when they agree to little (in which case the information that they have is so noisy as to be useless). © All Slides | Aswath Damodaran SUSTAINABLE GROWTH AND FUNDAMENTALS © All Slides | Aswath Damodaran  FUNDAMENTAL GROWTH RATES 19 Investment Current Return on in Existing Investment on Current Projects X Projects = Earnings $ 1000 12% $120 Investment Next Periodʼs Investment Return on Next + in Existing Return on in New Investment on Projects X Investment Projects X New Projects = Periodʼs $1000 12% $100 12% Earnings 132 Investment Change in Investment Return on + in Existing ROI from in New Investment on Projects X current to next Projects X New Projects Change in Earnings $1000 period: 0% $100 12% = $ 12 © All Slides | Aswath Damodaran  GROWTH RATE DERIVATIONS 20 In the special case where ROI on existing projects remains unchanged and is equal to the ROI on new projects Investment in New Projects Change in Earnings Current Earnings X Return on Investment = Current Earnings 100 $12 120 X 12% = $120 Reinvestment Rate X Return on Investment = Growth Rate in Earnings 83.33% X 12% = 10% in the more general case where ROI can change from period to period, this can be expanded as follows: Investment in Existing Projects*(Change in ROI) + New Projects (ROI) Change in Earnings Investment in Existing Projects* Current ROI = Current Earnings For instance, if the ROI increases from 12% to 13%, the expected growth rate can be written as follows: $1,000 * (.13 -.12) + 100 (13%) $23 $ 1000 *.12 = $120 = 19.17% © All Slides | Aswath Damodaran  ESTIMATING FUNDAMENTAL GROWTH FROM NEW INVESTMENTS: THREE VARIATIONS 21 Earnings Measure Reinvestment Measure Return Measure Earnings per share Retention Ratio = % of net Return on Equity = Net income retained by the Income/ Book Value of company = 1 – Payout Equity ratio Net Income from non-cash Equity reinvestment Rate = Non-cash ROE = Net assets (Net Cap Ex + Change in Income from non-cash non-cash WC – Change in assets/ (Book value of Debt)/ (Net Income) equity – Cash) Operating Income Reinvestment Rate = (Net Return on Capital or ROIC Cap Ex + Change in non- = After-tax Operating cash WC)/ After-tax Income/ (Book value of Operating Income equity + Book value of debt – Cash) © All Slides | Aswath Damodaran  I. EXPECTED LONG TERM GROWTH IN EPS 22 q When looking at growth in earnings per share, these inputs can be cast as follows: q Reinvestment Rate = Retained Earnings/ Current Earnings = Retention Ratio q Return on Investment = ROE = Net Income/Book Value of Equity q In the special case where the current ROE is expected to remain unchanged gEPS = Retained Earnings t-1/ NI t-1 * ROE = Retention Ratio * ROE = b * ROE q In 2008, using this approach on Wells Fargo: q Return on equity (based on 2008 earnings)= 17.56% q Retention Ratio (based on 2008 earnings and dividends) = 45.37% q Expected growth rate in earnings per share for Wells Fargo, if it can maintain these numbers. q Expected Growth Rate = 0.4537 (17.56%) = 7.97% © All Slides | Aswath Damodaran  ONE WAY TO PUMP UP ROE: USE MORE DEBT 23 Return on Equity = Return on capital + D/E (ROC - i (1-tax rate)) where Return on capital = EBITt (1 - tax rate) / Book value of Capitalt-1 D/E = BV of Debt/ BV of Equity i = Interest Expense on Debt / BV of Debt q In 1998, Brahma (now Ambev) had an extremely high return on equity, partly because it borrowed money at a rate well below its return on capital q Return on Capital = 19.91% q Debt/Equity Ratio = 77% q After-tax Cost of Debt = 5.61% q Return on Equity = ROC + D/E (ROC - i(1-t)) = 19.91% + 0.77 (19.91% - 5.61%) = 30.92% © All Slides | Aswath Damodaran  II. EXPECTED GROWTH IN NET INCOME FROM NON-CASH ASSETS 24 q A more general version of expected growth in earnings can be obtained by substituting in the equity reinvestment into real investments (net capital expenditures and working capital) and modifying the return on equity definition to exclude cash: q Net Income from non-cash assets = Net income – Interest income from cash (1- t) q Equity Reinvestment Rate = (Net Capital Expenditures + Change in Working Capital) (1 - Debt Ratio)/ Net Income from non-cash assets q Non-cash ROE = Net Income from non-cash assets/ (BV of Equity – Cash) q Expected GrowthNet Income = Equity Reinvestment Rate * Non-cash ROE q Th equity reinvestment rate, unlike the retention ratio, can be higher than 100%, and if it is, the expected growth rate in net income can exceed the return on equity. © All Slides | Aswath Damodaran  ESTIMATING EXPECTED GROWTH IN NET INCOME FROM NON- CASH ASSETS: COCA COLA IN 2010 25 q In 2010, Coca Cola reported net income of $11,809 million. It had a total book value of equity of $25,346 million at the end of 2009. Coca Cola had a cash balance of $7,021 million at the end of 2009, on which it earned income of $105 million in 2010. q Non-cash Net Income = $11,809 - $105 = $ 11,704 million q Non-cash book equity = $25,346 - $7021 = $18,325 million q Non-cash ROE = $11,704 million/ $18,325 million = 63.87% q Coca Cola had capital expenditures of $2,215 million, depreciation of $1,443 million and reported an increase in working capital of $335 million. Coca Cola’s total debt increased by $150 million during 2010. q Equity Reinvestment = 2215- 1443 + 335-150 = $957 million q Reinvestment Rate = $957 million/ $11,704 million= 8.18% q Expected growth rate in non-cash Net Income = 8.18% * 63.87% = 5.22% © All Slides | Aswath Damodaran  III. EXPECTED GROWTH IN EBIT AND FUNDAMENTALS: STABLE ROC AND REINVESTMENT RATE 26 q When looking at growth in operating income, the definitions are q Reinvestment Rate = (Net Capital Expenditures + Change in WC)/EBIT(1-t) q Return on Investment = ROC = EBIT(1-t)/(BV of Debt + BV of Equity- Cash) q Reinvestment Rate and Return on Capital q Expected Growth rate in Operating Income q = (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC q = Reinvestment Rate * ROC q Proposition: The net capital expenditure needs of a firm, for a given growth rate, should be inversely proportional to the quality of its investments. © All Slides | Aswath Damodaran  ESTIMATING GROWTH IN OPERATING INCOME, IF FUNDAMENTALS STAY LOCKED IN… 27 q In 1999, Cisco’s fundamentals were as follows: q Reinvestment Rate = 106.81% q Return on Capital =34.07% q Expected Growth in EBIT =(1.0681)(.3407) = 36.39% q As a potential investor in Cisco, what would worry you the most about this forecast? a. That Cisco’s return on capital may be overstated (why?) b. That Cisco’s reinvestment comes mostly from acquisitions (why?) c. That Cisco is getting bigger as a firm (why?) d. That Cisco is viewed as a star (why?) e. All of the above © All Slides | Aswath Damodaran  THE MAGICAL NUMBER: ROIC (OR ANY ACCOUNTING RETURN) AND ITS LIMITS 28 © All Slides | Aswath Damodaran  IV. OPERATING INCOME GROWTH WHEN RETURN ON CAPITAL IS CHANGING 29 q When the return on capital is changing, there will be a second component to growth, positive if the return on capital is increasing and negative if the return on capital is decreasing. q If ROCt is the return on capital in period t and ROC t+1 is the return on capital in period t+1, the expected growth rate in operating income will be: Expected Growth Rate = ROC t+1 * Reinvestment rate +(ROC t+1 – ROCt) / ROCt q In general, if return on capital and margins are changing and/or expected to change at a company, you are better off not using any of the sustainable growth equations to estimate growth. © All Slides | Aswath Damodaran  THE VALUE OF GROWTH 30 Expected growth = Growth from new investments + Efficiency growth = Reinv Rate * ROC + (ROCt-ROCt-1)/ROCt-1 Assume that your cost of capital is 10%. As an investor, rank these firms in the order of most value growth to least value growth. © All Slides | Aswath Damodaran TOP DOWN GROWTH © All Slides | Aswath Damodaran  ESTIMATING GROWTH WHEN OPERATING INCOME IS NEGATIVE OR MARGINS ARE CHANGING 32 q All of the fundamental growth equations assume that the firm has a return on equity or return on capital it can sustain in the long term. q When operating income is negative or margins are expected to change over time, we use a three-step process to estimate growth: q Estimate growth rates in revenues over time q Determine the total market (given your business model) and estimate the market share that you think your company will earn. q Decrease the growth rate as the firm becomes larger q Keep track of absolute revenues to make sure that the growth is feasible q Estimate expected operating margins each year q Set a target margin that the firm will move towards q Adjust the current margin towards the target margin q Estimate the capital that needs to be invested to generate revenue growth and expected margins q Estimate a sales to capital ratio that you will use to generate reinvestment needs each year. © All Slides | Aswath Damodaran  1. REVENUE GROWTH 33 © All Slides | Aswath Damodaran AIRBNB: TOTAL MARKET In its prospectus, Airbnb has expanded its estimate of market potential to $3.4 trillion, as evidenced in this excerpt from the prospectus: We have a substantial market opportunity in the growing travel market and experience economy. We estimate our serviceable addressable market (“SAM”) today to be $1.5 trillion, including $1.2 trillion for short-term stays and $239 billion for experiences. We estimate our total addressable market (“TAM”) to be $3.4 trillion, including $1.8 trillion for short-term stays, $210 billion for long-term stays, and $1.4 trillion for experiences. © All Slides | Aswath Damodaran  AIRBNB: MARKET SHARE 35 © All Slides | Aswath Damodaran  2. TARGET MARGINS (AND PATH THERE)… 36 © All Slides | Aswath Damodaran  AIRBNB IN NOVEMBER 2020: GROWTH AND PROFITABILITY 37 © All Slides | Aswath Damodaran  3. SALES TO INVESTED CAPITAL: A PATHWAY TO ESTIMATING REINVESTMENT 38 © All Slides | Aswath Damodaran  AIRBNB: REINVESTMENT AND PROFITABILITY 39 © All Slides | Aswath Damodaran  AGGREGATE VERSUS MARGINAL VALUES 40 q While sustainable growth equations are stated in terms of returns on capital (equity) or sales to capital the numbers that drive growth are returns on new investments, i.e., marginal returns on capital (equity) or marginal sales to capital ratios. q The marginal returns and sales to capital ratios can be computed by looking at changes from year to year: ("#$%&'()* ,)-./$! 0"#$%&'()* ,)-./$!"# ) q 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑅𝑂𝐶 = (,)2$3'$4 5&#('&6!"# 0,)2$3'$4 5&#('&6!"$ ) (7&6$3! 07&6$3!"# ) q 𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑅𝑂𝐶 = (,)2$3'$4 5&#('&6!"# 0,)2$3'$4 5&#('&6!"$ ) q As companies scale up, the marginal values for these variables can diverge from the aggregate values. q For companies where there are investing economies to scale, the marginal values can be significantly higher than the aggregate values. q For companies that are facing changing competitor or are entering new businesses, the marginal values can be lower than the aggregate values. Aswath Damodaran © All Slides | Aswath Damodaran