On the whole, it makes sense for long-term investors to invest in companies that are likely to grow over the long term.
And an obvious place to look for companies that are likely to generate long-term growth in the future is companies that have generated long-term growth in the past.
But how exactly should you measure a company’s historic growth rate?
There are a million ways you could do it, and that’s part of the problem. You have to narrow down the number of things you measure and deciding what to measure is not always easy.
Personally, I’ve usually measured growth as growth in revenues, earnings and dividends. However, I have recently moved away from earnings in search of something else which is a) more stable and b) more closely related to dividend sustainability.
That ‘something else’ has turned out to be a combination of tangible capital employed (which I’ll define shortly) and free cash flows (which I’ll define in an upcoming blog post).
Analysing companies with free cash flows and tangible capital employed is a lengthy topic and it will probably take a few blog posts to cover in full, so in this first blog post, I’ll just outline the three things I now use to measure a company’s growth rate.
1) Measure tangible capital employed growth
If you already know what tangible capital employed is then feel free to skip down to the section on how I actually measure its growth rate. If you’re not so sure, keep reading for a quick reminder.
To start with, let’s imagine we’ve started a company together; a barber’s shop. We’re going to invest some money into the business in order to get it up and running, and we’ll hire a professional barber to run the business on a day-to-day basis.
We’re going to rent a shop, fit it out with a barber’s chair, mirrors and so on. We’ll also stock up on scissors, shampoo and the various tools of the barber’s trade.
These are all assets of the business. As we buy these assets we’ll record them on the balance sheet.
We expect some assets to last several years, and these are known as fixed or non-current assets.
This could be the barber’s chair and perhaps even tools like scissors or shears if they’re expensive and long-lasting enough.
Other assets will be used up or turned into cash within a year, and these are known as current assets.
Cash at the bank is already cash, so that’s a current asset, but items like shampoo (which will typically be used up within a year) or beard oil (which will be used or sold within a year) are also current assets.
Now imagine our little barber’s shop is very busy and we want to expand. One of the main bottlenecks in the business is the barber’s chair. We have one chair, so our barber can only cut the hair of one person at a time.
We could hire two barbers and both could cut a customer’s hair at the same time, but there are limits to this. You can’t have ten barbers cutting someone’s hair at the same time and expect to get the job done in 1/1oth of the time it would take one barber (or as Fred Brooks said in The Mythical Man Month, “The bearing of a child takes nine months, no matter how many women are assigned.”)
If we want our business to carry out more haircuts and make more money, we’re going to have to buy another barber’s chair. Obviously, we’ll need to hire a second barber (who isn’t an asset, at least from an accounting point of view) and that barber will need scissors, shears, shampoo, and so on.
All this will increase our fixed and current assets and that’s the point:
There are few caveats to add at this point.
Caveat a) Ignore intangible assets
Companies can have intangible assets as well as tangible assets. The barber’s chair is a tangible asset, whereas an intangible asset could be computer software or (hypothetically) a five-year licence to manufacture and sell Burberry branded hair clips.
In most cases, intangible assets are quite small relative to tangible assets and I’m happy to ignore them on the assumption that they have no realisable value if the company goes bust (it will be much easier to sell a barber chair than some software developed internally to keep track of customers).
A far more problematic intangible asset is accounting “goodwill”. Goodwill is the price paid to acquire another company, above and beyond the value of the acquired company’s tangible assets.
As a somewhat oversimplified example, imagine our barber shop acquired Burberry outright.
Burberry currently has tangible assets of about £2 billion and a market value of close to £7 billion.
Following the acquisition (which I admit is a tad unlikely) we would record the £2 billion of tangible assets on our balance sheet. The £5 billion difference between the price paid and the tangible assets acquired would be recorded on our balance sheet as an intangible goodwill asset.
This can be a problem because goodwill is not a productive asset. It is just a way to account for the price paid above and beyond the value of an acquired company’s productive tangible assets.
This becomes a problem when measuring profitability, which I’ll cover in a future blog post. But for the sake of consistency, I’m also going to focus on tangible assets when measuring growth, which means ignoring intangible assets.
Caveat b) Subtract non-interest-bearing current liabilities
Another common tweak to assets is to deduct the value of short-term, non-interesting bearing liabilities.
In most cases, this is primarily short-term (e.g. 30-day) interest-free credit that suppliers offer to make it easier to sell their wares. In the case of our barber’s shop, it’s handy to be able to buy shampoo on interest-free credit, use that shampoo to wash some customers’ hair and then use the proceeds to pay off the supplier 30 days later.
By deducting short-term interest-free liabilities from our tangible assets we’re effectively pretending we paid for that shampoo (or whatever) with cash, rather than on credit.
Current assets minus non-interest-bearing current liabilities is a simplified calculation of working capital, so this final adjustment leaves us with tangible fixed assets plus working capital.
The sum of tangible fixed assets and working capital is more commonly known as tangible capital employed, and it’s the growth of this tangible capital employed that I’m really interested in.
Caveat c) Measure growth on a per-share basis
As shareholders, we should be interested primarily in a company’s per-share results rather than its aggregate results. A company with one factory could, for example, double the number of shares by raising new equity capital in a rights issue, and use that new capital to build a second factory.
This might double the company’s tangible capital employed and perhaps eventually its total revenues, earnings and dividends.
However, management may have doubled the company’s tangible capital employed, revenues, earnings and dividends, but that doubling would be split across double the number of shares, so it would make no difference to the company’s per-share results (and potentially no difference to shareholder wealth).
How I measure tangible capital employed growth
So after a somewhat lengthy detour, we can now focus on measuring the growth of a company’s tangible capital employed per share.
But there’s a snag: In the world of business, everything is volatile. That goes for revenues, earnings, dividends and yes, tangible capital employed.
And the more volatile something is, the more difficult it is to pick out any underlying growth trends.
For example, what if a company earned 100p per share ten years ago and 90p per share last year? Has the company grown over those ten years or not?
The answer is you have no idea.
Perhaps the latest earnings of 90p are not a good reflection of the company’s underlying earnings power (i.e. its ability to generate earnings under ‘normal’ conditions). Perhaps the company just had a bad year, or we’re in a recession. Perhaps under normal circumstances, it could have earned 200p this year, or perhaps 90p really is a good reflection of its current earnings potential.
Simply measuring the change in earnings, tangible capital employed or any volatile value between two single years is not very helpful.
Fortunately, Ben Graham came up with a simple and practical way to iron out at least some of this volatility. It isn’t perfect, but it’s a lot better than measuring growth between two single years.
Graham’s solution was to measure growth between two three-year periods. Here’s how it works:
- Get or calculate values for the feature we’re measuring going back ten years
- Calculate the average value for the oldest three-year period
- Calculate the average value for the latest three-year period
- Measure the growth rate between those two three-year periods
Let’s run through that process for Burberry (which I’ve owned for several years and is a holding in my model portfolio), using data from SharePad:
Get or calculate tangible capital employed per share going back ten years
We don’t need the whole ten years of data to measure growth rate, but we will need it to measure growth quality, profitability and some other handy ratios which I’ll cover in future blog posts. So we might as well grab the data now.
To calculate tangible capital employed per share we’ll need to extract the following values from the balance sheet (there are shorter ways to do it, but I’ve broken it down a bit more for this example so we can see the different components such as fixed and working capital):
- Total intangible assets (including goodwill)
- Non-current assets
- Current assets
- Current liabilities
- Current borrowings
- Average number of shares in issue (normally found at the back of the annual results in the accounting note relating to earnings per share)
The relevant calculations are:
Tangible fixed assets = non-current assets - intangible assets
Working capital = current assets - current liabilities + current borrowings
Tangible capital employed per share = (tangible fixed assets + working capital) / average number of shares in issue
You can also multiply tangible capital employed (TCE) per share by 100 to convert the value from pounds into pence.
Obviously, this is very laborious, so I’ve set up a spreadsheet to do most of the work. You can access it from the Free Resources page (and if you get my weekly email newsletter I’ll send out a direct link shortly).
Here’s a table showing the full set of data for Burberry going back ten years. I’ve also highlighted the oldest and newest ten-year periods for tangible capital employed per share which we’ll look at next:
Calculate the average value for the oldest three-year period
The table above shows tangible capital employed per share for the oldest three years to be 178p, 180p and 203p. The average for this period is then:
Oldest three-year average = (178p + 180p + 203p) / 3 = 187p
Calculate the average value for the latest three-year period
For the latest three years the values are 370p, 390p and 355p. The average is therefore:
Newest three-year average = (370p + 390p + 355p) / = 372p
Measure the growth rate between those two three-year periods
With an oldest three-year average tangible capital employed per share of 187p and a newest three-year average of 372p, I think it’s safe to say that Burberry’s tangible capital employed per share has grown. But by how much?
To calculate an annualised growth rate we need to do a bit of mathematical jiggery-pokery, which is another area where spreadsheets excel.
The calculation (and conversion to a percentage) is:
((new average / old average)(1/7) - 1) * 100%
The (1/7) bit means raising to the 1/7th power. We do this because there are seven years between those two three-year periods and we’re looking for the annual growth rate which, when applied over seven years, would give the correct total growth.
Think of it like this: If we had an annual growth rate and wanted to know the total growth rate over seven years we would add one to the growth rate (so 18% would become 1.18) and then we’d multiply it by itself seven times (i.e. raise it to the power 7) to get total growth over seven years.
Raising the total growth rate by the 1/7th power and then subtracting one does the same thing but in reverse.
For Burberry, the result is:
((372p / 187p)(1/7) - 1) * 100% = 10.3%
In other words, Burberry grew its tangible capital employed per share at an annualised rate of 10.3% over the last ten years.
The chart below shows what that looks like:
Asset growth is good, but unless you’re an asset stripper like Gordon Gekko, you’re not going to generate a return by forcing a company to sell off its assets.
As shareholders, a company’s assets are simply a tool which our hired managers use to generate cash, which they can then return to us in the form of dividends, share buybacks and so on.
But in order to pay out cash, a company first has to suck in cash from the outside world, and that’s where we’ll look next.
2) Measure revenue growth
Revenue, or turnover, is simply the amount of cash paid into the company by customers in return for the services and products it produces.
Revenue is typically quite stable from one year to the next and without revenue growth a company cannot generate long-term sustainable dividend growth.
Revenue is therefore a prime suspect as a way to measure growth, and it’s been one of my key growth measures for many years.
As with tangible capital employed, I’m interested in per-shares results rather than a company’s total revenues.
I also use the same Ben Graham approach to measuring revenue per share growth:
Get or calculate revenue per share going back ten years
Most companies don’t quote revenues per share in their annual results, so once again a spreadsheet is invaluable.
Here’s a table showing Burberry’s revenue per share over the last decade (again, the oldest and newest three-year periods are highlighted):
Calculate the average value for the oldest three-year period
The table shows revenue per share for the oldest three years to be 278.6p, 273.9p and 345.1p. The average for this period is then:
Oldest three-year average = (278.6p + 273.9p + 345.1p) / 3 = 299.2p
Calculate the average value for the latest three-year period
Burberry’s latest three revenue per share results are 569.1p, 629.9p and 642.0p, giving an average of:
Newest three-year average = (569.1p + 629.9p + 642.0p) / = 613.6p
Measure the growth rate between those two three-year periods
The total amount of growth between the old and new periods was 105.1% and the annualised growth rate is:
((613.6p / 299.2p)(1/7) - 1) * 100% = 10.8%
A near-11% growth rate is nothing to be sniffed at. It’s also satisfyingly close to the company’s tangible capital employed (satisfying because we’re using these different metrics in an attempt to measure the same thing, which is growth in the company’s underlying earnings power and ability to generate excess cash).
So now we’ve measured growth in the company’s tangible capital employed and growth in the amount of money that capital attracts from customers.
The last thing we’ll measure is growth in the amount of that money the company is able to return to shareholders.
3) Measure dividend growth
By measuring dividends, we’re now measuring three relatively stable aspects of the company which may provide a good indication of the company’s intrinsic growth:
- Tangible capital employed growth: Growth of the company’s productive physical assets
- Revenue growth: Growth of the amount of money those assets attract from customers
- Dividend growth: Growth of the amount of cash the company is able to return to shareholders (returns from share buybacks are reflected in the growth of the company’s per share results as the number of remaining shares declines)
Let’s take a quick look at Burberry’s dividend growth.
Get or calculate dividends per share going back ten years
Most companies do quote dividends per share, although a spreadsheet will still be useful for calculating the dividend growth rate.
As before, here’s a (very narrow) table showing Burberry’s dividend per share over the last decade:
Calculate the average value for the oldest three-year period
Dividends per share for the oldest three years were 12p, 14p and 20p. The average is:
Oldest three-year average = (12p + 14p + 20p) / 3 = 15.3p
Calculate the average value for the latest three-year period
The latest dividend per share figures are 37p, 38.9p and 41.3p, with an average of:
Newest three-year average = (37.0p + 38.9p + 41.3p) / = 39.0p
Measure the growth rate between those two three-year periods
Total dividend growth between those periods was 154.8%, giving an annualised growth rate of:
((39.0p / 15.3p)(1/7) - 1) * 100% = 14.3%
A 14.3% dividend growth rate is clearly above the 10% or so growth rates of tangible capital employed and revenues.
This means such a high dividend growth rate is unlikely to be sustainable over the longer-term unless Burberry’s asset and growth rates can increase.
But this post isn’t really about analysing Burberry; it’s about measuring a company’s growth rate. So let’s have a quick look at all these various results from Burberry one chart and then we can move on to our final task, which is to measure a company’s overall growth rate:
4) Measure the company’s average growth rate across tangible capital employed, revenues and dividends
We could just leave it there and have three separate figures for growth. But I’d rather have a single figure and averaging the growth rate from tangible capital employed, revenues and dividends seems like a sensible idea.
This will give us a final Growth Rate figure:
Growth Rate = (Tangible capital employed per share growth rate + revenue per share growth rate + dividend per share growth rate) / 3
For Burberry, this gives us a final Growth Rate figure of:
Burberry's Growth Rate = (10.8% + 10.3% + 14.3%) / 3 = 11.8%
A near-12% growth rate is well above average, although whether Burberry can maintain such growth in the years ahead is a question for another day.
One small step towards a reasonably detailed analysis
This Growth Rate figure is not a magic bullet. In fact, it’s only one part of an even remotely detailed analysis.
But it’s a start, and from the research I’ve done, I think it does a pretty decent job of estimating a company’s underlying growth rate, i.e. growth in its ability to generate earnings, cash and dividends under normal conditions.
From Growth Rate to Growth Quality
In the next instalment of this series, I’ll cover Growth Quality, which attempts to measure the consistency of a company’s dividend growth, as well as some factors (including free cash flow) which are likely to either enable or undermine sustainable dividend growth.
Pleased to see you have finally decided to work with free cash flow, which is what myself and others have been saying for sometime now. You didn’t like that idea before John because you said it was difficult to measure CapEx. Did you hit on a way to do that? I tend to use maintenance CapEx which can be either estimated from depreciation (Phil Oakley approach) or by subtracting growth CapEx estimated from the PPE growth. This leads to CROIC (Cash Return on Invested Capital) which is the metric which I tend to use in place of ROCE. CROIC=FCF/(Total Assets-Current liabilities-Cash-Deferred taxes). Of course all these are averaged over a business cycle. I find ten years leads to a good average but suppresses changes in trends so for me five years is the optimum figure which is around the business cycle 3-5 years anyway.
Hi Andrew
My new approach to ROCE is in development, but currently it’s based on maintenance free cash flow and tangible capital employed.
The calculation is a bit long-winded so I’m going to cover it in a blog post in a week or two. Next week I’m looking at my Growth Quality score, and then probably the week after I’ll look at Profitability (i.e. maintenance free cash flow return on tangible capital employed).
As you say, these are all averaged over the business cycle, which I take as ten years, and so far the metric seems to have some use. Capital intensive and uncompetitive companies tend to have low MFCF/TCE scores and ‘good’ companies seem to have high scores.
I’m in the process of building a test stock screen so I can rank the whole market by these new metrics to see if they work in practice as well as in theory.
Hello John
Thank you for a very interesting article, the explanation was particularly clear and easy to follow.
I am fine with the maths, but could not see why there is a seven year period between the two three year averages – what am I missing!.
I will certainly give it a try and hopefully reduce selecting companies that subsequently cut their dividend.
Thanks
Hi George
This one always seems to cause a lot of confusion. It’s seven years because:
1) In the Burberry example, the ‘old 3yr average’ includes data from 2009, 2010 and 2011 and is centred around the year 2010.
2) The latest 3yr period covers 2016, 2017 and 2018 and is centred around 2017.
3) The gap between 2010 and 2017 is seven years, and the same applies regardless the actual company or years being analysed.
Hopefully that makes sense, but if not just let me know.
Hi John, Started reading this and must admit running short on time so will have to come back to it lol !
One initial comment is the definition of tangible assets and the usefulness of measuring their growth.
You draw a distintion between a piece of software and a chair — surely you are not overly serious about the differential here in terms of usefulness to the business?
The chair forms a useful function and costs X
The software forms a useful function and costs Y
Is one really less tangible than the other, or better assessed as valuable in terms of it’s assistance to the business growth?
I would also argue in a digital age – many assets are now classified as intangible. Like the brand of Burberry for example – isn’t this a bigger generator of business than the desks and chairs and stands for the clothes in the shops (each which is classed as tangible), which have a pretty limited value aspect in terms of growth in the business?
Take Microsoft for example as something at the other end of argument, that manufactures software which generates all the growth and all the value in the company — it’s intangible.
Measuring the growth in the tangible assets of Microsoft seems of somewhat limited value.
LR
Hi LR
“surely you are not overly serious about the differential here [between tangible and intangible assets] in terms of usefulness to the business?”
No, I’m not saying anything about differences in their utility; at least I didn’t intend to.
The distinction between tangible and intangible is more relevant to profitability (which I’ll cover in a future blog post) than growth, and more about ignoring goodwill than non-goodwill intangibles like software.
Perhaps ideally I might just exclude goodwill, but I don’t because of data limitations (ShareScope doesn’t differentiate between goodwill and non-goodwill intangibles).
In practical terms I think the difference between ignoring just goodwill and ignoring all intangibles is unlikely to make much difference, so I’m comfortable ignoring them.
And capitalising intangible expenses is a pretty grey area anyway and it’s an easy way to boost reported profits if the CFO is so inclined.
For example, our barber might have taken the local shampoo salesman out to lunch in order to get a better deal on our bulk shampoo orders. Perhaps we’re building a long-term relationship with this supplier, so we might capitalise the expense as an intangible ‘supplier goodwill’ expense, therefore moving the expense from the income statement to the balance sheet, and boosting reported profits in the process.
The general rule of thumb in accounting is to be conservative and to assume that this sort of thing won’t have any lasting value, hence why R&D is typically a revenue expense rather than a capital expense.
But anyway, legitimate intangible assets are typically quite small and I’m not too fussed whether I ignore them or not.
As for Burberry’s brand, it isn’t on the balance sheet as an asset at all. All of the marketing, advertising and design expenses that build the brand are revenue expenses, not capital expenses. And the same goes for the company’s culture, supplier goodwill, customer goodwill and most of the other intangible things that make great companies great.
The only way this sort of off-balance sheet intangible asset gets onto a balance sheet is when the company is acquired, at which point it turns into accounting goodwill on the acquirer’s balance sheet.
So in summary (you always know when a comment is too long when you have to summarise!) a) I’m mostly interested in ignoring goodwill and b) I’ll explain a bit more about why that’s the case when I write about profitability in a week or two.
No it’s not too long John, it’s good to hammer it out. The goodwill aspect has always been a bit of a puzzler for moi aussi – so I need to get my head around it anyway.
Regards LR
Hi John,
I tend to ignore intangible asset for even large companies which can form a significant part of the balance sheet. Intangible assets merely reflect a premium a company can place on its product but it tells you very little on the day to day operation of a company. By just focusing on tangible assets it allows you to determine how capital intensive the business is and if it generates a good margin.
I think this also makes it easier for an investor to put a premium on the company rather than accepting the premium management and accounting team believe which can often be too generous.
Hi Reg
Yes, intangible goodwill definitely clouds the issue of capital intensity and that’s something I’m going to cover in an upcoming post on profitability.
Hi John,
The only things I do take notice of in a company dependent on intangible assets when looking at day to day operation is R&D costs and marketing. People overlook the importance of this.
Not too long ago Valeant Pharmaceutical hit the headlines because it bought companies at an inflated price and then stripped R&D whilst hiking the price of the drugs. Initially, EPS looked wonderful but cash flow was a dud. Valeant Pharma financial shenanigans became clear eventually. Although large companies like Merck and Pfizer highlighted their concern with Valeants Pharma’s unsustainable business model much earlier on. This was an attempt to ward off attacks from activist investors who demanded pharma companies to trim down on R&D like Valeant Pharmaceutical.
An interesting point Reg. One of the things that makes cash flow popular is that it’s relatively harder for CFO’s to fiddle with compared to earnings.
John – Off topic, what’s your view on the ASOS fall out — I guess you will have run your eyeball over it at some stage, despite it not having a 10 year track record as a public company and living on the AIM market?
I was thinking more of it’s margin loss of 4% down to 2% and it was once 6.25%
Impact on Next?
LR
Hi LR, sorry old chap but no; ASOS is way off my radar and I’m busy enough without looking far outside my ‘circle of competence’.
As for Next, I’m taking my usual ‘wait and see’ approach (otherwise known as doing nothing).
Bought some Next – what the hxll — It has to be a reasonable time, when everyone thinks retail is finished forever – usually it isn’t the case.
Wolfson did and at a much higher price than moi — I was also encouraged by the online performance and I’m thinking, hoping that the rate of shop sale falls will slow, eventually.
The reason for highlighting ASOS, was the severity of the fall and the fact it was deemed the AIM success above all others – it’s margins reflect perhaps that it’s not just about where and how you sell, but what you sell.
LR
Hi, why are you including cash & equivalents under current assets and current borrowings in your calculation? While you exclude LT financial borrowings.
I would like to think about capital employed as follows: Net Debt + SHE; i.e. All financial / interest bearing borrowings – cash & equivalents or cash-like items (i.e. financial receivables from affiliates, related parties) + SHE.
This is what funds the tangible, intangible assets and net working capital of the business.
As such I am not clear, why you’d include cash under current assets and current borrowings in your calculation.
What if the management decides to fund the business via long-term borrowings and make current borrowings equal to 0. Then you working capital level will decrease, while also decrease capital employed amount, which will distort your return on capital employed calculation.
Am I missing something in your logic?
Thanks for your writings!
Hi Ali (sorry for the delayed reply)
There are various ways to define and calculate capital employed, with the two main ones being:
1) debt + equity
2) fixed assets + working capital
There are some minor differences but for the most part these are the same thing, e.g.
non-current assets + current assets = total assets
non-current liabilities + current liabilities = total liabilities
total assets – total liabilities = equity
equity + total borrowings = capital employed
and
total liabilities – total borrowings = non-interest-bearing liabilities
so
total assets – non-interest-bearing liabilities = capital employed
In the blog post I wrote:
fixed assets + current assets – current liabilities + current borrowings = capital employed
which for the most part is the same as the previous calculation. The only difference is non-current interest-free liabilities, which might be pension or tax related, but in most cases should be pretty inconsequential.
Although having said that, IFRS 16 may end up putting future lease liabilities on the balance sheet as a relatively large interest-free non-current liability. I’d have to look at a few retailer’s balance sheets to see how that’s panning out.
You may also be interested to know that I’ve recently changed how I calculate capital employed, largely because of how I get data from my data provider. I now use the debt + equity approach, although I still use total borrowings rather than net borrowings. My opinion is that cash on the balance sheet is a) usually inconsequential, b) should be productive and not just used to net off against debts.
Hopefully that makes sense but a blog comment is not the best place to describe these things!
John
Thanks, I’ll give a thought to your answer, but I understand the logic, your exclusion doesn’t necessarily exclude financial liabilities, but it is a nuance for pension & tax related items.
Regarding IFRS 16, what I see is that, it puts all future rental obligations for shops in retailers balance sheet (there is a discount etc. but that is the idea); but on contrary will overstate EBIT / EBITDA level; because it will put part of such rental / lease expense under financing items. That is at least what I have seen in some European companies (electronics retailers etc.).
Some disclose cash rental expenses in their CF statements, which you can adjust and get the real rental expense of the business; but it gives a very nice incentive to underperforming companies to overstate EBITDA simply because part of rental is classified within financial expenses, which I have seen in a number of cases.
Nice blog btw, just discovered and I like the way you present your ideas, helpful for me.