QUALIPORT
Who Needs Growth?

By Maynard Paton (TMFMayn)
June 11, 2001

Carburton Street, London -- We'll start with some words from Warren Buffett, taken from his 1992 Shareholders' Letter. I've highlighted the key point.

  "In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here:  The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset. "

"The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value."

So, do growing businesses actually make good investments with regard to the discounted cash flows they generate for shareholders? Given the stock market's typical optimism towards growth companies, as opposed to the indifference subjected towards companies that have more limited prospects, I would say "usually not". Let's plug a few numbers into the theory and try and underpin my bold statement.

Take your pick

Let's imagine we've got £1,000 to buy the one of following four companies (coincidentally, all the companies are up for sale at £1,000 each). Each of the four has a different growth rate and a valuation typically applied  to that growth rate by the stock market.

Company          Price to earnings     Prospective ten-year
                       ratio               growth rate

Allied Tobacco          12.5                   0%
Tescbury's              16.7                   6%
McPizza King            20.0                  10%
Baltiham Media          50.0                  30%

So, assuming...

* each company's earnings are a proxy for free cash that goes straight into shareholders' pockets, and;
* the discount rate to calculate the net present value (NPV) of our future cash flows is 5%.

...which company should we purchase?

Let's look at Allied Tobacco. Its price to earnings (P/E) ratio of 12.5 equates to an earnings yield (and in our case, a free cash flow yield) of 8%. Hence, with our £1,000 spent and zero profit growth anticipated, we'd receive £80 a year. Discounting all the payments by 5% gives us the net present value of the company's cash flows, or in other words, the company's future cash flows expressed in "today's money".

Year     Cash Flow      NPV
            (£)         (£)

  1        80.00       76.19
  2        80.00       72.56
  3        80.00       69.11
  4        80.00       65.82
  5        80.00       62.68
  6        80.00       59.70
  7        80.00       56.85
  8        80.00       54.15
  9        80.00       51.57
 10        80.00       49.11

Total     800.00      617.74

After ten years then, Allied Tobacco would have generated us a total of £800 or -- in today's money -- £617.74.

Using the same process, here's the table for Tescbury's...

Year     Cash Flow      NPV
            (£)         (£)

  1        60.00       57.14
  2        63.60       57.69
  3        67.42       58.24
  4        71.46       58.79
  5        75.75       59.35
  6        80.29       59.92
  7        85.11       60.49
  8        90.22       61.06
  9        95.53       61.64
 10       101.37       62.23

Total     790.85      596.55

... the table for McPizza King...

Year     Cash Flow      NPV
            (£)         (£)

  1        40.00       38.10
  2        46.00       41.72
  3        52.90       45.70
  4        60.84       50.05
  5        69.96       54.82
  6        80.45       60.04
  7        92.52       65.75
  8       106.40       72.02
  9       122.36       78.87
 10       140.72       86.39

Total     812.15      593.45

...and the table for Baltiham Media.

Year     Cash Flow      NPV
            (£)         (£)

  1        20.00       19.05
  2        26.00       23.58
  3        33.80       29.20
  4        43.94       36.15
  5        57.12       44.76
  6        74.26       55.41
  7        96.54       68.61
  8       125.50       84.94
  9       163.15      105.17
 10       212.09      130.20

Total     852.39      597.07

And finally, here's the summary of the cumulative cash flows from each business for the next ten years.

Company           Accumulated   Total NPV of
                   Cash flow     Cash flow
                     (£m)          (£m)

Allied Tobacco      800.00        617.74
Tescbury's          790.85        596.55
McPizza King        812.15        593.45
Baltiham Media      852.39        597.07

Close call

It's very close, but in terms of the cash received over the next ten years, Allied Tobacco would be the better investment. Granted, the total cash generated by Allied Tobacco (of £800) is less than that generated by two of the other companies. But of course, £1 generated today obviously has a greater value than £1 generated tomorrow. So, with Allied Tobacco returning larger amounts of cash sooner rather than later, the company wins out because the net present value of its cash flows is larger than that produced by the other three companies.

However, if we move beyond the tenth year and assume each company's growth rate remains the same, then the merits of Allied Tobacco would gradually reduce. Sooner or later, with its 30% growth rate, Baltiham Media would take the overall honours.

Reality

That said, growth rates of 15% and certainly 30% per annum, sustained over ten years, are unusual to say the least! The combination of extrapolating such annual profit improvements with a rich valuation usually courts investment disaster. While Baltiham Media may eventually become the most attractive company of the four on paper, there are substantial inherent risks involved with investing in such a company.

On the other hand, Allied Tobacco, with zero growth expected, should be a less risky proposition in terms of disappointing with its future profits. Remember, too, that given all the valuations and growth rates, it will take over ten years before the discounted cash flows produced by Allied Tobacco are surpassed by one of the other three companies.

Summary

Ultimately, the function of any business is to generate cash for its owners. And as Buffett implies, the company's rate of growth is largely irrelevant. All that counts for shareholders is the amount of free cash generated now and expected in the future compared to the company's present valuation. As long as the company has a stable business, produces pots of free cash and is valued at a suitably attractive price, who needs growth?

More: The Free Cash Flow Yield