ESTIMATINGGROWTH

Growthcanbegood,badorneutral…

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TheValueofGrowth

¨ Whenvaluingacompany,itiseasytogetcaughtupinthedetailsofestimatinggrowthandstartviewinggrowthasa“good”,i.e.,thathighergrowthtranslatesintohighervalue.

¨ Growth,though,isadouble-edgedsword.¤ Thegoodsideofgrowthisthatitpushesuprevenuesandoperatingincome,perhapsatdifferentrates(dependingonhowmarginsevolveovertime).

¤ Thebadsideofgrowthisthatyouhavetosetasidemoneytoreinvesttocreatethatgrowth.

¤ Theneteffectofgrowthiswhetherthegoodoutweighsthebad.

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WaysofEstimatingGrowthinEarnings

¨ Lookatthepast¤ Thehistoricalgrowthinearningspershareisusuallyagoodstartingpointforgrowthestimation

¨ Lookatwhatothersareestimating¤ Analystsestimategrowthinearningspershareformanyfirms.Itisusefultoknowwhattheirestimatesare.

¨ Lookatfundamentals¤ Ultimately,allgrowthinearningscanbetracedtotwofundamentals- howmuchthefirmisinvestinginnewprojects,andwhatreturnstheseprojectsaremakingforthefirm.

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HistoricalGrowth

GrowthI155

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HistoricalGrowth

¨ Historicalgrowthratescanbeestimatedinanumberofdifferentways¤ ArithmeticversusGeometricAverages¤ SimpleversusRegressionModels

¨ Historicalgrowthratescanbesensitiveto¤ Theperiodusedintheestimation(startingandendingpoints)¤ Themetricthatthegrowthisestimatedin..

¨ Inusinghistoricalgrowthrates,youhavetowrestlewiththefollowing:¤ Howtodealwithnegativeearnings¤ Theeffectsofscalingup

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Motorola:ArithmeticversusGeometricGrowthRates

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ATest

¨ YouaretryingtoestimatethegrowthrateinearningspershareatTimeWarnerfrom1996to1997.In1996,theearningspersharewasadeficitof$0.05.In1997,theexpectedearningspershareis$0.25.Whatisthegrowthrate?

a. -600%b. +600%c. +120%d. Cannotbeestimated

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DealingwithNegativeEarnings

¨ Whentheearningsinthestartingperiodarenegative,thegrowthratecannotbeestimated.(0.30/-0.05=-600%)

¨ Therearethreesolutions:¤ Usethehigherofthetwonumbersasthedenominator(0.30/0.25=120%)

¤ Usetheabsolutevalueofearningsinthestartingperiodasthedenominator(0.30/0.05=600%)

¤ Usealinearregressionmodelanddividethecoefficientbytheaverageearnings.

¨ Whenearningsarenegative,thegrowthrateismeaningless.Thus,whilethegrowthratecanbeestimated,itdoesnottellyoumuchaboutthefuture.

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TheEffectofSizeonGrowth:CallawayGolf

Year NetProfit GrowthRate1990 1.801991 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%¨ GeometricAverageGrowthRate=102%

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ExtrapolationanditsDangers

Year NetProfit1996 $122.301997 $247.051998 $499.031999 $1,008.052000 $2,036.252001 $4,113.23¨ Ifnetprofitcontinuestogrowatthesamerateasithasinthepast6years,theexpectednetincomein5yearswillbe$4.113billion.

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AnalystEstimates

GrowthII162

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AnalystForecastsofGrowth

¨ Whilethejobofananalystistofindunderandovervaluedstocksinthesectorsthattheyfollow,asignificantproportionofananalyst’stime(outsideofselling)isspentforecastingearningspershare.¤ Mostofthistime,inturn,isspentforecastingearningspershareinthenextearningsreport

¤ Whilemanyanalystsforecastexpectedgrowthinearningspershareoverthenext5years,theanalysisandinformation(generally)thatgoesintothisestimateisfarmorelimited.

¨ AnalystforecastsofearningspershareandexpectedgrowtharewidelydisseminatedbyservicessuchasZacksandIBES,atleastforU.Scompanies.

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Howgoodareanalystsatforecastinggrowth?

¨ AnalystsforecastsofEPStendtobeclosertotheactualEPSthansimpletimeseriesmodels,butthedifferencestendtobesmall

Study Grouptested Analyst TimeSeriesError ModelError

Collins&HopwoodValueLineForecasts 31.7% 34.1%Brown&Rozeff ValueLineForecasts 28.4% 32.2%Fried&Givoly EarningsForecaster 16.4% 19.8%¨ Theadvantagethatanalystshaveovertimeseriesmodels

¤ tendstodecreasewiththeforecastperiod(nextquarterversus5years)¤ tendstobegreaterforlargerfirmsthanforsmallerfirms¤ tendstobegreaterattheindustrylevelthanatthecompanylevel

¨ Forecastsofgrowth(andrevisionsthereof)tendtobehighlycorrelatedacrossanalysts.

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Aresomeanalystsmoreequalthanothers?

¨ AstudyofAll-AmericaAnalysts(chosenbyInstitutionalInvestor)foundthat¤ ThereisnoevidencethatanalystswhoarechosenfortheAll-America

Analystteamwerechosenbecausetheywerebetterforecastersofearnings.(Theirmedianforecasterrorinthequarterpriortobeingchosenwas30%;themedianforecasterrorofotheranalystswas28%)

¤ However,inthecalendaryearfollowingbeingchosenasAll-Americaanalysts,theseanalystsbecomeslightlybetterforecastersthantheirlessfortunatebrethren.(ThemedianforecasterrorforAll-Americaanalystsis2%lowerthanthemedianforecasterrorforotheranalysts)

¤ EarningsrevisionsmadebyAll-Americaanalyststendtohaveamuchgreaterimpactonthestockpricethanrevisionsfromotheranalysts

¤ TherecommendationsmadebytheAllAmericaanalystshaveagreaterimpactonstockprices(3%onbuys;4.7%onsells).Fortheserecommendationsthepricechangesaresustained,andtheycontinuetoriseinthefollowingperiod(2.4%forbuys;13.8%forthesells).

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TheFiveDeadlySinsofanAnalyst

¨ TunnelVision:Becomingsofocusedonthesectorandvaluationswithinthesectorthatyoulosesightofthebiggerpicture.

¨ Lemmingitis:Strongurgefelttochangerecommendations&reviseearningsestimateswhenotheranalystsdothesame.

¨ StockholmSyndrome:Referstoanalystswhostartidentifyingwiththemanagersofthefirmsthattheyaresupposedtofollow.

¨ Factophobia (generallyiscoupledwithdelusionsofbeingafamousstoryteller):Tendencytobasearecommendationona“story” coupledwitharefusaltofacethefacts.

¨ Dr.Jekyll/Mr.Hyde:Analystwhothinkshisprimaryjobistobringininvestmentbankingbusinesstothefirm.

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PropositionsaboutAnalystGrowthRates

¨ Proposition1:Thereiffarlessprivateinformationandfarmorepublicinformationinmostanalystforecaststhanisgenerallyclaimed.

¨ Proposition2:Thebiggestsourceofprivateinformationforanalystsremainsthecompanyitselfwhichmightexplain¤ whytherearemorebuyrecommendationsthansellrecommendations

(informationbiasandtheneedtopreservesources)¤ whythereissuchahighcorrelationacrossanalystsforecastsandrevisions¤ whyAll-Americaanalystsbecomebetterforecastersthanotheranalysts

aftertheyarechosentobepartoftheteam.¨ Proposition3:Thereisvaluetoknowingwhatanalystsare

forecastingasearningsgrowthforafirm.Thereis,however,dangerwhentheyagreetoomuch(lemmingitis)andwhentheyagreetolittle(inwhichcasetheinformationthattheyhaveissonoisyastobeuseless).

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It’sallinthefundamentals

GrowthIII168

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FundamentalGrowthRates

Investmentin ExistingProjects$ 1000

Current Return onInvestment on Projects12%

X = CurrentEarnings$120

Investmentin ExistingProjects$1000

Next Periodʼs Return onInvestment12%

XInvestmentin NewProjects$100

Return onInvestment onNew Projects12%

X+ = Next PeriodʼsEarnings132

Investmentin ExistingProjects$1000

Change inROI from current to nextperiod: 0%

XInvestmentin NewProjects$100

Return onInvestment onNew Projects12%

X+ Change in Earnings$ 12=

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GrowthRateDerivations

In the special case where ROI on existing projects remains unchanged and is equal to the ROI on new projects

Investment in New ProjectsCurrent Earnings

Return on Investment Change in EarningsCurrent Earnings=X

Reinvestment Rate X Return on Investment = Growth Rate in Earnings

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)Investment in Existing Projects* Current ROI

Change in EarningsCurrent Earnings=

100120 X 12% = $12

$120

For instance, if the ROI increases from 12% to 13%, the expected growth rate can be written as follows:

83.33% X 12% = 10%

$1,000 * (.13 - .12) + 100 (13%)$ 1000 * .12

$23$120= = 19.17%

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EstimatingFundamentalGrowthfromnewinvestments:Threevariations

EarningsMeasure ReinvestmentMeasure ReturnMeasure

Earningspershare RetentionRatio=%ofnetincomeretainedbythecompany=1– Payoutratio

ReturnonEquity=NetIncome/BookValueofEquity

NetIncomefromnon-cashassets

EquityreinvestmentRate=(NetCapEx+Changeinnon-cashWC– ChangeinDebt)/(NetIncome)

Non-cashROE=NetIncomefromnon-cashassets/(Bookvalueofequity– Cash)

OperatingIncome ReinvestmentRate=(NetCapEx+Changeinnon-cashWC)/After-taxOperatingIncome

ReturnonCapitalorROIC=After-taxOperatingIncome/(Bookvalueofequity+Bookvalueofdebt– Cash)

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I.ExpectedLongTermGrowthinEPS

¨ Whenlookingatgrowthinearningspershare,theseinputscanbecastasfollows:¤ ReinvestmentRate=RetainedEarnings/CurrentEarnings=Retention

Ratio¤ ReturnonInvestment=ROE=NetIncome/BookValueofEquity

¨ InthespecialcasewherethecurrentROEisexpectedtoremainunchanged

gEPS =RetainedEarningst-1/NIt-1 *ROE=RetentionRatio*ROE=b*ROE

¨ Proposition1:Theexpectedgrowthrateinearningsforacompanycannotexceeditsreturnonequityinthelongterm.

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EstimatingExpectedGrowthinEPS:WellsFargoin2008

¨ Returnonequity(basedon2008earnings)=17.56%¨ RetentionRatio(basedon2008earningsanddividends)=45.37%

¨ ExpectedgrowthrateinearningspershareforWellsFargo,ifitcanmaintainthesenumbers.ExpectedGrowthRate=0.4537(17.56%)=7.97%

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RegulatoryEffectsonExpectedEPSgrowth

¨ Assumenowthatthebankingcrisisof2008willhaveanimpactonthecapitalratiosandprofitabilityofbanks.Inparticular,youcanexpectthatthebookcapital(equity)neededbybankstodobusinesswillincrease30%,startingnow.

¨ AssumingthatWellscontinueswithitsexistingbusinesses,estimatetheexpectedgrowthrateinearningspershareforthefuture.

NewReturnonEquity=Expectedgrowthrate=

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OnewaytopumpupROE:Usemoredebt

ROE=ROC+D/E(ROC- i (1-t))where,

ROC=EBITt (1- taxrate)/BookvalueofCapitalt-1D/E=BVofDebt/BVofEquityi =InterestExpenseonDebt/BVofDebtt=Taxrateonordinaryincome

¨ NotethatBookvalueofcapital=BookValueofDebt+BookvalueofEquity- Cash.

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DecomposingROE:Brahmain1998

¨ Brahma(nowAmbev)hadanextremelyhighreturnonequity,partlybecauseitborrowedmoneyataratewellbelowitsreturnoncapital¤ ReturnonCapital=19.91%¤ Debt/EquityRatio=77%¤ After-taxCostofDebt=5.61%¤ ReturnonEquity=ROC+D/E(ROC- i(1-t))

=19.91%+0.77(19.91%- 5.61%)=30.92%

¨ Thisseemslikeaneasywaytodeliverhighergrowthinearningspershare.What(ifany)isthedownside?

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DecomposingROE:TitanWatches(India)in2000

¨ ReturnonCapital=9.54%¨ Debt/EquityRatio=191%(bookvalueterms)¨ After-taxCostofDebt=10.125%¨ ReturnonEquity=ROC+D/E(ROC- i(1-t))

=9.54%+1.91(9.54%- 10.125%)=8.42%

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II.ExpectedGrowthinNetIncomefromnon-cashassets

¨ ThelimitationoftheEPSfundamentalgrowthequationisthatitfocusesonpershareearningsandassumesthatreinvestedearningsareinvestedinprojectsearningthereturnonequity.Totheextentthatcompaniesretainmoneyincashbalances,theeffectonnetincomecanbemuted.

¨ Amoregeneralversionofexpectedgrowthinearningscanbeobtainedbysubstitutingintheequityreinvestmentintorealinvestments(netcapitalexpendituresandworkingcapital)andmodifyingthereturnonequitydefinitiontoexcludecash:¤ NetIncomefromnon-cashassets=Netincome– Interestincomefrom

cash(1- t)¤ EquityReinvestmentRate=(NetCapitalExpenditures+ChangeinWorking

Capital)(1- DebtRatio)/NetIncomefromnon-cashassets¤ Non-cashROE=NetIncomefromnon-cashassets/(BVofEquity– Cash)¤ ExpectedGrowthNetIncome =EquityReinvestmentRate*Non-cashROE

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Estimatingexpectedgrowthinnetincomefromnon-cashassets:CocaColain2010

¨ In2010,CocaColareportednetincomeof$11,809million.Ithadatotalbookvalueofequityof$25,346millionattheendof2009.

¨ CocaColahadacashbalanceof$7,021millionattheendof2009,onwhichitearnedincomeof$105millionin2010.

¨ CocaColahadcapitalexpendituresof$2,215million,depreciationof$1,443millionandreportedanincreaseinworkingcapitalof$335million.CocaCola’stotaldebtincreasedby$150millionduring2010.¤ EquityReinvestment=2215- 1443+335-150=$957million¤ Non-cashNetIncome=$11,809- $105=$11,704million¤ Non-cashbookequity=$25,346- $7021=$18,325million¤ ReinvestmentRate=$957million/$11,704million=8.18%¤ Non-cashROE=$11,704million/$18,325million=63.87%¤ Expectedgrowthrate=8.18%*63.87%=5.22%

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III.ExpectedGrowthinEBITAndFundamentals:StableROCandReinvestmentRate

¨ Whenlookingatgrowthinoperatingincome,thedefinitionsare¤ ReinvestmentRate=(NetCapitalExpenditures+ChangeinWC)/EBIT(1-t)

¤ ReturnonInvestment=ROC=EBIT(1-t)/(BVofDebt+BVofEquity-Cash)

¨ ReinvestmentRateandReturnonCapitalExpectedGrowthrateinOperatingIncome=(NetCapitalExpenditures+ChangeinWC)/EBIT(1-t)*ROC=ReinvestmentRate*ROC

¨ Proposition:Thenetcapitalexpenditureneedsofafirm,foragivengrowthrate,shouldbeinverselyproportionaltothequalityofitsinvestments.

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EstimatingGrowthinOperatingIncome,iffundamentalsstayunchanged¨ Cisco’sFundamentals

¤ ReinvestmentRate=106.81%¤ ReturnonCapital=34.07%¤ ExpectedGrowthinEBIT=(1.0681)(.3407)=36.39%

¨ Motorola’sFundamentals¤ ReinvestmentRate=52.99%¤ ReturnonCapital=12.18%¤ ExpectedGrowthinEBIT=(.5299)(.1218)=6.45%

¨ Cisco’sexpectedgrowthrateisclearlymuchhigherthanMotorola’ssustainablegrowthrate.AsapotentialinvestorinCisco,whatwouldworryyouthemostaboutthisforecast?a. ThatCisco’sreturnoncapitalmaybeoverstated(why?)b. ThatCisco’sreinvestmentcomesmostlyfromacquisitions(why?)c. ThatCiscoisgettingbiggerasafirm(why?)d. ThatCiscoisviewedasastar(why?)e. Alloftheabove

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TheMagicalNumber:ROIC(oranyaccountingreturn)anditslimits

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IV.OperatingIncomeGrowthwhenReturnonCapitalisChanging

¨ Whenthereturnoncapitalischanging,therewillbeasecondcomponenttogrowth,positiveifthereturnoncapitalisincreasingandnegativeifthereturnoncapitalisdecreasing.

¨ IfROCt isthereturnoncapitalinperiodtandROCt+1 isthereturnoncapitalinperiodt+1,theexpectedgrowthrateinoperatingincomewillbe:

ExpectedGrowthRate=ROCt+1 *Reinvestmentrate+(ROCt+1 – ROCt)/ROCt

¨ Ifthechangeisovermultipleperiods,thesecondcomponentshouldbespreadoutovereachperiod.

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Motorola’sGrowthRate

¨ Motorola’scurrentreturnoncapitalis12.18%anditsreinvestmentrateis52.99%.

¨ WeexpectMotorola’sreturnoncapitaltoriseto17.22%overthenext5years(whichishalfwaytowardstheindustryaverage)ExpectedGrowthRate=ROCNewInvestments*ReinvestmentRateCurrent+{[1+(ROCIn5years-ROCCurrent)/ROCCurrent]1/5-1}=.1722*.5299+{[1+(.1722-.1218)/.1218]1/5-1}=.1629or16.29%

¨ OnewaytothinkaboutthisistodecomposeMotorola’sexpectedgrowthinto¤Growthfromnewinvestments:.1722*5299=9.12%¤Growthfrommoreefficientlyusingexistinginvestments:16.29%-9.12%=7.17%

NotethatIamassumingthatthenewinvestmentsstartmaking17.22%immediately,whileallowingforexistingassetstoimprovereturnsgradually

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TheValueofGrowth

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.

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TopDownGrowth

GrowthIV186

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EstimatingGrowthwhenOperatingIncomeisNegativeorMarginsarechanging

¨ Allofthefundamentalgrowthequationsassumethatthefirmhasareturnonequityorreturnoncapitalitcansustaininthelongterm.

¨ Whenoperatingincomeisnegativeormarginsareexpectedtochangeovertime,weuseathreestepprocesstoestimategrowth:¤ Estimategrowthratesinrevenuesovertime

n Determinethetotalmarket(givenyourbusinessmodel)andestimatethemarketsharethatyouthinkyourcompanywillearn.

n Decreasethegrowthrateasthefirmbecomeslargern Keeptrackofabsoluterevenuestomakesurethatthegrowthisfeasible

¤ Estimateexpectedoperatingmarginseachyearn Setatargetmarginthatthefirmwillmovetowardsn Adjustthecurrentmargintowardsthetargetmargin

¤ Estimatethecapitalthatneedstobeinvestedtogeneraterevenuegrowthandexpectedmarginsn Estimateasalestocapitalratiothatyouwillusetogeneratereinvestmentneeds

eachyear.

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TeslainJuly2015:GrowthandProfitability

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Tesla:ReinvestmentandProfitability

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Expected Growth Rate

Equity Earnings Operating Income

HistoricalFundamentalsAnalysts HistoricalFundamentals

Stable ROE Changing ROE

ROE * Retention RatioROEt+1*Retention Ratio+ (ROEt+1-ROEt)/ROEt

Stable ROC

ROC * Reinvestment Rate

Changing ROC

ROCt+1*Reinvestment Rate+ (ROCt+1-ROCt)/ROCt

Negative Earnings

1. Revenue Growth2. Operating Margins3. Reinvestment NeedsEarnings per share Net Income

Stable ROE Changing ROE

ROE * Equity Reinvestment Ratio

ROEt+1*Eq. Reinv Ratio+ (ROEt+1-ROEt)/ROEt

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