Many factors can derail any business forecast.

Forecasting future growth is considerably imprecise

Forecasting sales or profits many years into the future is considerably more imprecise, and a great many factors can derail any business forecast. 

There are many investors who make decisions solely on the basis of their own forecasts of future growth. After all, the faster the earnings or cash flow of a business is growing, the greater that business’s present value. 

Difficulties confronting growth-oriented investors

Yet several difficulties confront growth-oriented investors. 

• First, such investors frequently demonstrate higher confidence in their ability to predict the future than is warranted. 
• Second, for fast-growing businesses even small differences in one’s estimate of annual growth rates can have a tremendous impact on valuation.  
• Moreover, with so many investors attempting to buy stock in growth companies, the prices of the consensus choices may reach levels unsupported by fundamentals. 
• Investors may at times be lured into making overly optimistic projections based on temporarily robust results, thereby causing them to overpay for mediocre businesses. 
• When growth is anticipated and therefore already discounted in securities prices, shortfalls will disappoint investors and result in share price declines.

When a good business can become a bad investment

 As Warren Buffett has said, “For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments.” 

Growth investors tend to oversimplify growth into a single number

Another difficulty with investing based on growth is that while investors tend to oversimplify growth into a single number, growth is, in fact, comprised of numerous moving parts which vary in their predictability. 

Sources of earnings growth

For any particular business, for example, earnings growth can stem from increased unit sales related 

• to predictable increases in the general population, 
• to increased usage of a product by consumers, 
• to increased market share, 
• to greater penetration of a product into the population, or 
• to price increases. 

Specifically, a brewer might expect to sell more beer as the drinking-age population grows but would aspire to selling more beer per capita as well. Budweiser would hope to increase market share relative to Miller. The brewing industry might wish to convert whiskey drinkers into beer drinkers or reach the abstemious segment of the population with a brand of nonalcoholic beer. Over time companies would seek to increase price to the extent that it would be expected to result in increased profits. 

Some of these sources of earnings growth are more predictable than others. 

• Growth tied to population increases is considerably more certain than growth stemming from changes in consumer behavior, such as the conversion of whiskey drinkers to beer. 
• The reaction of customers to price increases is always uncertain. 

On the whole it is far easier to identify the possible sources of growth for a business than to forecast how much growth will actually materialize and how it will affect profits. 

The company's growth plans: Your approach as an investor.

Good growth is exciting for any company that you own.

Growth can be through organic growth or through mergers and acquisitions.

However, as an investor, you should assign little importance to growth plans of the company in your investing decision.

It is far more important the company sets out the right strategy, since growth will follow in due course.

Many short-term growth targets get in the way of taking the right long-term decisions.

As an investor, you should be willing to ride out patchy results, considering this to be part and parcel of business.

On mergers and acquisitions, the investors should have a very clear stance: it is important to avoid the urge to grow for growth's sake; the focus should be on acquisitions that make sense and not overpaying.  It is important to avoid watering down a quality business with inferior acquisitions.

Growth is often seen as the best measure of corporate success.

Growth is often seen as the best measure of corporate success.

A company growing at a rate of 15% per year is doubling in size every five years.

Rapid-growth companies can be defined as those with annual growth rates of 20% or more.

Super-growth companies show a compound growth rate of around 40% per year.

MARKET SHARE INFORMATION

Market share information can provide valuable support to the analysis and interpretation of changes in a company’s turnover.

The majority of companies provide turnover growth details in their annual report, but few offer any details of market share.

When turnover is known for several firms competing in the same market, it is possible to devise a simple alternative to market share information.

Company	A	A	B	B	C	C	D	D	TOTAL	TOTAL
Year	1	2	1	2	1	2	1	2	1	2
Sales ($bn)	2.5	2.9	16	16.3	5.9	5.5	17.2	18.8	41.6	43.5
Share (%)	6	7	39	37	14	13	41	43	100	100

How their share of the joint total market changes can readily be followed.  If this is done for a number of years, the analysis can form the basis for a performance comparison.

RAPID GROWTH COMPANY IS NOT ALWAYS A SAFE AND SOUND INVESTMENT.  RAPID GROWTH CANNOT ALWAYS BE SUSTAINED. 

A common view is that a rapid-growth company is safe and sound investment.

However evidence suggests that rapid growth cannot always be sustained.  There are of course exceptions.  

BE CAUTIOUS OF GROWTH THROUGH DIVERSIFICATION OR ACQUISITION, THROUGH INCREASING DEBT FINANCING AND THROUGH TURNOVER GROWTH WITHOUT PROFIT.

·         However, it is probably safer to assume that rapid growth, particularly if associated with diversification, often through acquisitions, will not continue.

·         If high compound growth rates are matched by increasing debt financing, extreme caution is called for.

·         For some companies, turnover growth is seen as the prime objective and measure of success, even when it is being achieved at the cost of profitability.  In the late 1990s, e-business provided many extreme examples of this.

ONE-PERSON COMPANY

• GROWTH THROUGH DIVERSIFICATION, COMMONLY THROUGH ACQUISITION.

Being pushed towards diversification to fuel continued growth is often the final challenge for the one-person company.  Having proved itself in one business sector it moves into new areas, commonly through acquisition.  More often than not its old skills prove not to be appropriate in the new business, attention is distracted from the core business, and it is viewed as having lost the golden touch.  Its survival may depend on new management and financial restructuring.

• WHEN A ONE-PERSON COMPANY’S GROWTH SLOWS AND CRITICISM MOUNTS

When a one-person company’s growth slows and criticism mounts, two scenarios may occur. 

• ·         In one, the individual running the company begins to take increasingly risky decisions in the hope to returning to previous levels of profit growth. 
• ·         In the other, recognising that there is little that can be done immediately to improve operating performance, the individual steps outside the law and accepted business practice to sustain his or her personal image and lifestyle.  Often in these companies other executives are reluctant to rock the boat and go along with the deception.

The distinction between Profit and Cash. A business can be profitable but short of cash.

Cash is completely different from profit, a fact that is not always properly appreciated.

It is possible, and indeed quite common, for a business to be profitable but short of cash.

Among the differences are the following:

1. Money may be collected from customers more slowly (or more quickly) than money is paid to suppliers.
2. Capital expenditure (unless financed by hire purchase or similar means) has an immediate impact on cash.  The effect on profit, by means of depreciation, is spread over a number of years.
3. Taxation, dividends and other payments to owners are an appropriation of profit.  Cash is taken out of the business which may be more or less than the profit.
4. An expanding business will have to spend money on materials, items for sale, wages, etc. before it completes the extra sales and gets paid.  Purchases and expenses come first.  Sales and profit come later.

Growing versus Non-growing company. Value Investing versus Growth Investing.

A growing company versus a non-growing company


Given the choice, you should choose to invest in a company that is growing its revenues, earnings, and free cash flows over time.  This company continues to grow its intrinsic value and over time, you will be well rewarded for investing in it.


Is investing into growing companies the same as growth investing?

Let us illustrate using company Y.  Company Y is a company that is growing its revenues, and earnings 15% per year, consistently and predictably for the last 10 years.   

At certain times, Company Y is available at a P/E of 10.  Buying Company Y at this stage is a bargain.  It is available at a bargain price.  This is value investing.  If you use PEG ratio of Peter Lynch, it is available at a PEG ratio of 10/15 which is < 1.   

At other times, Company Y is available at a P/E of 20.  Buying Company Y at this stage is not value investing.  Those who buy at this P/E may feel they are also buying a bargain, as they projected that the earnings of Company Y is going to be great and the growth in earnings higher than the 15% per annum in the past.  Maybe they projected that the earnings will be growing  30% per year.   This is growth investing.  If you use PEG ratio of Peter Lynch, it is still available at a PEG ratio of < 1 (= 20/30).

Thus, is there a difference between value investing and growth investing, from a bargain perspective?   There appear to be 2 sides of the same coin.  Those buying into the stock using these strategies are of the opinion they are buying a bargain.   

However, there are differences too.   Historically, value investing has outperformed growth investing when assessed over a long time frame of investing.  But beware of such analysis.   Among the value investing stocks selection, many of the companies did not perform as expected and the fundamentals tanked.   Likewise, those stocks in growth investing, projected to grow at high rate and bought at high P/E, failed to deliver the growth and did not perform as expected.  

Let us learn from Buffett.  Stays with the company that you understand.  This company must have business with durable competitive advantage.  Its management must have unquestionable integrity.  Finally, buy them at a fair price.  

Yes, search out for the growing companies.  I too love such companies.   Above all, emphasizes the quality of the growth of business and its management.   Finally, look at the price (valuation).   Whether it is value or growth investing, buy growing companies at reasonable price (GARP). 

Look at growth from the perspective of investment required to support the growth. Profitable Growth Occurs Only Within a Franchise.

Summary 
Now to summarize about growth:

1. growth at a competitive disadvantage destroys value,
2. growth on a level playing field neither creates nor destroys value, and
3. it is only growth behind the protection of barriers to entry that creates value.

Growth 
 

The standard view of short term analysts is that growth is your friend. Growth is always valuable.  That is wrong!  
 

Growth is relatively rarely valuable in the long run. And you can see why with some simple arithmetic.  I am not going to look at growth from the perspective of sales, I am going to look at it from the perspective of investment required to support the growth. 

• Now the investment required to support the growth is zero then of course it is profitable—that happens almost never (For Duff & Phelps or Moody’s perhaps). 
• At a minimum you have A/R and other elements of working capital to support growth. 

Suppose the investment required is $100 million, and I have to pay 10% annually to the investors who supplied that $100 million dollars.   The cost of the growth is 10% of $100 million or $10 million dollars.   

1.  Suppose I invest that $100 million at a competitive disadvantage. 

• Suppose I am Wal-Mart planning to compete against a well-entrenched competitor in Southern Germany, am I going to earn 10% on that investment?  Almost never.  In that case, I will be lucky to earn anything; perhaps I earn $6 million. 
• But the net contribution of the growth is the $10 million cost of the funds minus the $6 million benefit which is minus $4 million dollars for every $100 million invested. 
• Growth at a competitive disadvantage has negative value.  

 

2.  Suppose it is like the automotive industry or like most industries with no barriers to entry, it is a level playing field so the return will be driven to 10% cost by the entry of other competitors. 

• So I am going to pay $10 million, I am going to make $10 million so the growth has zero value.   

3.  Profitable Growth Occurs Only Within a Franchise 

• The only case where growth has value is where the growth occurs behind the protection of an identifiable competitive advantage. 
• Growth only has value where there are sustainable competitive advantages. 
• And in that case, usually, what barriers to entry means is there are barriers to companies stealing market share from each other.
• There is usually stable market share which is symptomatic of that last situation that means in the long run, the company will grow at the industry rate. 
• And in the long run, almost all industries grow at the rate of global GDP.   

So in these three situations, the growth only matters in the last one where its profitable (growing within a franchise) is.

• And the critical issue in valuation is either management or the G&D approach will tell you the extent to which that is important or you have a good reliable valuation and there is no value to the growth because there are no barriers to entry. 
• Or it is down here (growth is profitable) and there obviously you want to get the growth for free.
• You could pay a full earnings power value and get a decent return. (Buffett with Coke-Cola in 1988).  

Introduction to a Value Investing Process by Bruce Greenblatt at the Value Investing Class Columbia Business School 
Edited by John Chew at Aldridge56@aol.com                           
studying/teaching/investing Page 27

Notes from video lecture by Prof Bruce Greenwald
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

Growth or the lack of it, is integral to a valuation exercise

The value of a business, a share of stock or any other productive asset is the present value of its future cash flows.

However, value is easier to define than to measure (easier said than done).

Valuing a business (or any productive asset) requires estimating its future performance and discounting the results to present value.  The probable future performance includes whatever GROWTH (or SHRINKAGE) is ASSUMED.

SO GROWTH (OR LACK OF IT) IS INTEGRAL TO A VALUATION EXERCISE.

This supports the point that the phrase value investing is redundant.  Investing is the deliberate determination that one pays a price lower than the value being obtained.  Only speculators pay a price hoping that through growth the value  rises above it.

Growth doesn't equate directly with value either.  

Growing earnings can mean growing value.  But growing earnings can also mean growing expenses, and sometimes expenses growing faster than revenues.  Growth adds value only when the payoff from growth is greater than the cost of growth.

A company reinvesting a dollar of earnings to grow by 99 cents is not helping its shareholders and is not a value stock, though it may be a growth stock.

Value investing is conventionally defined as buying companies bearing low ratios of price-to-earnings, price-to-book value, or high dividend yields.  But these metrics do not by themselves make a company a value investment.  It isn't that simple.  Nor does the absence of such metrics prevent an investment from bearing a sufficient margin of safety and qualitative virtues to justify its inclusion in a value investor's portfolio.

Is Growth Always A Good Thing?

Rapid growth in revenue and earnings may be top priorities in corporate boardrooms, but these priorities are not always best for shareholders. We are often tempted to invest large amounts in risky or even mature companies that are beating the drum for fast growth, but investors should check that a company's growth ambitions are realistic and sustainable.

Growth's Attraction
Let's face it, it's hard not to be thrilled by the prospect of growth. We invest in growth stocks because we believe that these companies are able to take shareholder money and reinvest it for a return that is higher than what we can get elsewhere.

Besides, in traditional investing wisdom, growth in sales earnings and stock performance are inexorably linked. In his book "One Up on Wall Street," investment guru Peter Lynch preaches that stock prices follow corporate earnings over time. The idea has stuck because many investors look far and wide for the fastest-growing companies that will produce the greatest share-price appreciation.



Is Growth a Sure Thing?
That said, there is room to debate this rule of thumb. In a 2002 study of more than 2,000 public companies, California State University finance professor Cyrus Ramezani analyzed the relationship between growth and shareholder value. His surprising conclusion was that the companies with the fastest revenue growth (average annual sales growth of 167% over a 10-year period) showed, over the period studied, worse share price performance than slower growing firms (average growth of 26%). In other words, the hotshot companies could not maintain their growth rates, and their stocks suffered.

The Risks
Fast growth looks good, but companies can get into trouble when they grow too fast. Are they able to keep pace with their expansion, fill orders, hire and train enough qualified employees? The rush to boost sales can leave growing companies with a deepening difficulty to obtain their cash needs from operations. Risky, fast-growing startups can burn money for years before generating a positive cash flow. The higher the rate of spending money for growth, the greater the company's odds of later being forced to seek more capital. When extra capital is not available, big trouble is brewing for these companies and their investors.

Companies often try increasingly big - and risky - deals to push up growth rates. Consider the serial acquirer WorldCom. In the 1990s, the company racked up growth rates of more than 20% by buying up little-known telecom companies. It later required larger and larger acquisitions to show impressive revenue percentages and earnings growth. In hopes of sustaining growth momentum, WorldCom CEO Bernie Ebbers agreed to pay a whopping $115 billion for Sprint Corp. However, federal regulators blocked the deal on antitrust grounds. WorldCom's prospects for growth collapsed, along with the company's value. The lesson here is that investors need to consider carefully the sustainability of deal-driven growth strategies.

Being Realistic About Growth
Eventually every fast-growth industry becomes a slow-growth industry. Some companies, however, still pursue expansion long after growth opportunities have dried up. When managers ignore the option of offering investors dividends and stubbornly continue to pour earnings into expansions that generate returns lower than those of the market, bad news is on the horizon for investors.

For example, take McDonald's - as it experienced its first-ever losses in 2003, and its share price neared a 10-year low, the company finally began to admit that it was no longer a growth stock. But for several years beforehand, McDonald's had shrugged off shrinking profits and analysts' arguments that the world's biggest fast-food chain had saturated its market. Unwilling to give up on growth, McDonald's accelerated its rate of restaurant openings and advertising spending. Expansion not only eroded profits but ate up a huge chunk of the company's cash flow, which could have gone to investors as large dividends.

CEOs and managers have a duty to put the brakes on growth when it is unsustainable or incapable of creating value. That can be tough since CEOs normally want to build empires rather than maintain them. At the same time, management compensation at many companies is tied to growth in revenue and earnings.

However, CEO pride doesn't explain everything: the investing system favors growth. Market analysts rate a stock according to its ability to expand; accelerating growth receives the highest rating. Furthermore, tax rules privilege growth since capital gains are taxed in a lower tax bracket while dividends face higher income-tax rates.

The Bottom Line
Justifications for fast growth can quickly pile up, even when it isn't the most prudent of priorities. Companies that pursue growth at the cost of sustaining themselves may do more harm than good. When evaluating companies with aggressive growth policies, investors need to determine carefully whether these policies have higher drawbacks than benefits.


Read more: http://www.investopedia.com/articles/fundamental/03/082003.asp#ixzz2KA5lFtVB

Growth can either ADD or DETRACT from an investment's value/

Growth in sales, earnings, and assets can either add or detract from an investment's value.

Growth can add to the value when the return on invested capital is above average, thereby assuring that when a dollar is being invested in the company, at least a dollar of market value is being created.

However, growth for a business earning low returns on capital can be detrimental to shareholders.  For example, the airline business has been a story of incredible growth, but its inability to earn decent returns on capital have left most owners of these companies in a poor position.

Dividends and Total Returns

During the bull market, the pursuit of rapidly growing businesses
obscured the real nature of equity returns. But growth isn't all there
is to successful investing; it's just one piece of a larger puzzle.
Total return includes not only price appreciation, but income as well.


And what causes price appreciation? In strictly theoretical terms,
there's only one answer: anticipated dividends. Earnings are just a
proxy for dividend-paying power. And dividend potential is not solely
driven by growth of the underlying business--in fact, rapid growth in
certain capital-intensive businesses can actually be a drag on
dividend prospects.

Investors who focus only on sales or earnings growth--or even just
the appreciation of the stock price--stand to miss the big picture. In
fact, a company that isn't paying a healthy dividend may be setting
its shareholders up for an unfortunate fate.

In Jeremy Siegel's The Future for Investors, the market's top
professor analyzed the returns of the original S&P 500 companies
from the formation of the index in 1957 through the end of 2003.

What was the best-performing stock? Was it in color televisions
(remember Zenith)? Telecommunications (AT&T T)? Groundbreaking
pharmaceuticals (Syntex/Roche)? Surely, it must have been a
computer stock (IBM IBM)?

None of the above. The best of the best hails not from a hot, rapidly
growing industry, but instead from a field that was actually
surrendering customers the entire time: cigarette maker Philip
Morris, now known as Altria Group MO. Over Siegel's 46-year time
frame, Philip Morris posted total returns of an incredible 19.75% per
year.

What was the secret? Credit a one-two punch of high dividends and
profitable, moat-protected growth. Philip Morris made some
acquisitions over the years, which were generally successful--but the
overwhelming majority of its free cash flow was paid out as
dividends or used to repurchase shares. As Marlboro gained market
share and raised prices, Philip Morris grew the core business at a
decent (if uninspiring) rate over the years. But what if the company-
-listening to the fans of growth and the foes of taxes--attempted to
grow the entire business at 19.75% per year? At that rate it would
have subsumed the entire U.S. economy by now.

The lesson is that no business can grow faster than the economy
indefinitely, but that lack of growth doesn't cap investor returns.
Amazingly, by maximizing boring old dividends and share buybacks, a
low-growth business can turn out to be the highest total return
investment of all time. As Siegel makes abundantly clear, "growth
does not equal return." Only profitable growth--in businesses
protected by an economic moat--can do that.


http://news.morningstar.com/classroom2/course.asp?docId=145248&page=3&CN=COM

Warren Buffett's approach to Growth. Growth on its own is not a valuable thing as a rule.

Benjamin Graham's approach.

Look first at Assets.
Then look at Earnings Power - making sure that they are protected by the assets.


Warren Buffett's approach.


Look at Assets and Earnings Power.
Only then, look to pay something for Growth.
Growth is only valuable if the return on investment in growth is greater than the cost of capital.
If not, growth can destroy value.
Growth on its own is not a valuable thing as a rule.
If you are going to buy growth, you better be sure of the franchise value.

A rapidly growing company presents special problems in valuation.

A rapidly growing company presents special problems in valuation. John Burr Williams (1938:560) succinctly writes "They had high hopes for their business, but no logical evaluation of these hopes in terms of stock prices. The very fact that [the company] was one of the hardest of all stocks to appraise rationally was the reason why it sold at the most extravagant prices, for speculation ever feeds on mystery, as we have seen before."

The problem with estimating an approximate appraisal value for rapidly growing companies is presented most clearly in the St. Petersburg Paradox. As David Durand wrote: "With growth stocks, the uncritical use of conventional discount formulas is particularly likely to be hazardous; for, as we have seen, growth stocks represent the ultimate in investments of long duration. Likewise, they seem to represent the ultimate in difficulty of evaluation." 

Is faith in speculation about future earnings more, or less, reasonable than faith in appraisal of today's value?

Reliance on the earnings estimates of experts can range from blind faith at one end of the spectrum to reasoned faith at the other end.. 


Even if an investor knows the difference between either cash flow or "free" cash flow, however defined, and true long-term economic earnings, and even if an investor accepts the operating definition of earnings used by experts, the acceptance of their estimates of earnings and growth in earnings constitutes an act of faith. 


Is faith in speculation about future earnings more, or less, reasonable than faith in appraisal of today's value?


Forward-looking statements about capital spending plans, R&D projects, share (re)purchase programs, and other uncommitted contingent activities find their public forum in press releases that are carefully worded to avoid class action lawsuits by disgruntled shareholders.

The important point is that growth per se does not always create value for the common stock owners. As John Burr Williams wrote (1938: 419): "That a non-growing industry can be profitable is shown ... , and that a fast-growing industry can be unprofitable is shown ... "

Earnings Growth: Good Growth and Bad Growth

GROWTH FIGURES FOR ANHEUSER-BUSCH

Take Anheuser-Busch. Ten-year figures to 2002, using the Value Line summaries, show the following:

Year	Earnings per share	Return on equity %	Return on capital %
1993	.89	23.0	14.9
1994	.97	23.4	15.2
1995	.95	22.2	14.3
1996	1.11	27.9	17
1997	1.18	29.2	15.6
1998	1.27	29.3	16.5
1999	1.47	35.8	17.7
2000	1.69	37.6	18.2
2001	1.89	42.0	18.8
2002	2.20	63.4	21.9

GROWTH IN EPS

For Mary Buffett and David Clark, earnings per share growth, and its ability to keep well ahead of inflation, is a key factor in the investment strategies of Warren Buffett. Earnings that are consistently increased are an indication of a quality company, soundly managed, with little or no reliance on commodity type products. This leads to predictability of future earnings and cash flows.

On the other hand, with a company whose earnings fluctuate, future cash flows are less predictable. The reasons may be poor management, poor quality or an over reliance on products that are susceptible to price reductions.

Take an imaginary company with the following earnings per share:

Year	EPS
1	2.00
2	2.25
3	2.98
4	1.47
5	1.88
6	-.65
7	2.75
8	2.20
9	1.98
10	3.01

The only conclusion that follows from these figures is that this company has good years and bad years. Year 11 might be great, it might be dreadful, or it might be average. The only certainty here is the unpredictability.

Of course, a fall in margins for one or two years may be as a result of once only factors and this can provide buying opportunities.

The difficulty is making the judgment as to 

• whether there is something permanently wrong, or 
• whether the problem has been isolated and resolved.

WARREN BUFFETT AGAIN ON GROWTH

For Warren Buffett the important thing is not that a company grows (he points to the growth in airline business that has not resulted in any real benefits to stockholders) but that returns grow. In 1992, he said this:

‘Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value.
In the case of a low-return business requiring incremental funds, growth hurts the investor.’


http://www.buffettsecrets.com/company-growth.htm

WHAT WARREN BUFFETT LOOKS FOR IN COMPANY GROWTH

An investor likes to see a company grow because, if profits grow, so do returns to the investor. The important thing for the investor, however, is that the company increases the returns to shareholders. A company that grows, at the expense of shareholder returns, is not generally a good investment. As Warren Buffett said in 1977:

‘Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5 % increase in earnings per share.’

WARREN BUFFETT AGAIN ON GROWTH

For Warren Buffett the important thing is not that a company grows (he points to the growth in airline business that has not resulted in any real benefits to stockholders) but that returns grow. In 1992, he said this:

‘Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value.

In the case of a low-return business requiring incremental funds, growth hurts the investor.’

What Warren Buffett Looks for in Company Growth

WHAT WARREN BUFFETT LOOKS FOR IN COMPANY GROWTH

An investor likes to see a company grow because, if profits grow, so do returns to the investor. The important thing for the investor, however, is that the company increases the returns to shareholders. A company that grows, at the expense of shareholder returns, is not generally a good investment. As Warren Buffett said in 1977:

‘Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5 % increase in earnings per share.’

COMPOUNDING EFFECT OF GROWTH

Regular growth in earnings per share can have a compound effect if all, or substantially all, of the profits are retained. A company, for example, with earnings per share of 40 cents growing regularly 9 % would, in ten years produce earnings per share of 87 cents.

Of course, if the investor can do better with retained earnings than the company can, his or her interests are better served by a full distribution of profits.

PAST GROWTH AS A PREDICTABILITY FACTOR

Although a consistent record of increases in earnings per share is not of itself an absolute predictor of either further increases, or the rate of any increases,Benjamin Graham believed that it was a factor worthy of consideration.

In addition, it is logical to conclude that a company that has had regular and consistent increases in earnings per share over a protracted period is soundly managed.

WARREN BUFFETT AGAIN ON GROWTH

For Warren Buffett the important thing is not that a company grows (he points to the growth in airline business that has not resulted in any real benefits to stockholders) but that returns grow. In 1992, he said this:

‘Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value.

In the case of a low-return business requiring incremental funds, growth hurts the investor.’

GROWTH FIGURES FOR ANHEUSER-BUSCH

Take Anheuser-Busch. Ten-year figures to 2002, using the Value Line summaries, show the following:

Year	Earnings per share	Return on equity %	Return on capital %
1993	.89	23.0	14.9
1994	.97	23.4	15.2
1995	.95	22.2	14.3
1996	1.11	27.9	17
1997	1.18	29.2	15.6
1998	1.27	29.3	16.5
1999	1.47	35.8	17.7
2000	1.69	37.6	18.2
2001	1.89	42.0	18.8
2002	2.20	63.4	21.9

GROWTH IN EPS

For Mary Buffett and David Clark, earnings per share growth, and its ability to keep well ahead of inflation, is a key factor in the investment strategies of Warren Buffett. Earnings that are consistently increased are an indication of a quality company, soundly managed, with little or no reliance on commodity type products. This leads to predictability of future earnings and cash flows.

On the other hand, with a company whose earnings fluctuate, future cash flows are less predictable. The reasons may be poor management, poor quality or an over reliance on products that are susceptible to price reductions.

Take an imaginary company with the following earnings per share:

Year	EPS
1	2.00
2	2.25
3	2.98
4	1.47
5	1.88
6	-.65
7	2.75
8	2.20
9	1.98
10	3.01

The only conclusion that follows from these figures is that this company has good years and bad years. Year 11 might be great, it might be dreadful, or it might be average. The only certainty here is the unpredictability.

Of course, a fall in margins for one or two years may be as a result of once only factors and this can provide buying opportunities.

The difficulty is making the judgment as to whether there is something permanently wrong, or whether the problem has been isolated and resolved.

http://www.buffettsecrets.com/company-growth.htm

Have an opinion on future growth - How can the company increase its earnings?

It is only rational to have an opinion on future growth.  Otherwise, how could you ever choose a stock?

When forming that opinion, back up quantitative information with qualitative factors.

For example, ask what management is doing to make a positive impact on earnings.

According to Peter Lynch, there are 5 basic ways a company can increase earnings:

• reduce costs; 
• raise prices; 
• expand into new markets;
• sell more of its products to the old markets; or
• revitalize, close or otherwise dispose of a losing operation.

When management is enacting growth-promoting activities, earnings may be temporarily flat.  They often soon take a giant step up.

Benjamin Graham saw a vulnerability in a high growth rate and in high returns on capital - the two normally go together.

So what's there to worry about in good earnings?  Exceptionally high earnings often attract rough competitors.  

The good part is that high earnings lure enthusiastic new investors, who often bid the share into the stratosphere.


Comment:
Buy good quality growth companies.
Assess the quality of the business and the management.
Then do the valuation.
These are the basics of the QVM or QMV approach to investing.

Avoiding "BAD" Growth

Investing in growth companies would be a lot easier if all business growth were created equal, but, unfortunately, it is not.

Investors must be wary of "bad" growth.  By bad growth, we mean growth in a business that is likely to produce an unattractive return on the capital invested to generate that growth.

For instance, although all the major airlines were able to achieve substantial growth of their business, Southwest Airlines was the only carrier that was able to generate a level of retun on invested capital that justified the rapid reinvestment in the business. 

Bad growth often stems from a "growth for growth's sake" mentality that results in costly acquired growth or misguided attempts to diversify the business. 

Investors shold be wary of growth initiatives that depend on the integration of sizable acquired businesses or that stray from a company's core mission.

Speculative-Growth Stocks - What's the Growth Trend?

Rapid sales growth won't do us any good if it can't be sustained.

We want staying power, not sales growth of 50% one year and shrinkage the next.

Even though it has only been around for a few years, Yahoo has been one of the most consistent Internet stocks around, growing steadily without a lot of wild swings from quarter to quarter.  

• The pace of that growth has been steadily declining (from 230% in 1997 to 120% in the first quarter of 2000), but that's to be expected as a company gets bigger and grows from a larger base.  
• Yahoo has demonstrated a lot of staying power, at least by the standards of Internet stocks.

ROE and Internet Stocks

As an example, consider the fastest growing segment of 1999, Internet stocks.

Most Internet companies are growing rapidly, but few of them are generating profits.



Apart from America Online AOL and its 25% ROE in 1999, none have generated a high return on capital. 


In 1999, the ROE for market darling Amazon.com AMZN was negative 270%.

• In other words, for each dollar shareholders had invested in the company, Amazon lost $2.70.  
• To replenish the lost capital, the company must either issue debt or turn to shareholders for more money -  and there are still plenty of people willing to pony up the money to own a piece of Amazon.  
• If Amazon is going to justify its price, it will eventually have to generate good returns on capital, and whether it can do that depends on which pundits you listen to.  

But there is no argument that returns on capital are the engine that drives stock prices in the long run.


Companies that go on to earn good returns on capital - ROEs of more than 15% or 20% - will probably make good investments.   

Those that struggle to earn a decent return will probably be wretched investments, regardless of how fast they grow.  

So, if someone tries to talk you into investing $10,000 in a restaurant or a few hundred share of an Internet stock, don't ask how fast the company will grow.  Ask how the heck it is going to earn a good return on its capital.