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.
