Forecasting Growth

[nextbigthing]

Hey all.


Dividends are usually easy to assess based on historical data and industry type etc. This makes it easy to make factual rational decisions.

But what about growth? It's vital to increasing the shareprice and therefore vital for one to fully understand and estimate. But how does one work out growth when it's potentially subjective?

For companies with historical data, it seems reasonably straight forward. Take Mainfreight as an example. Plenty of data on their past performance and enough data about their expansion plans to estimate the revenue in a few years time. Easy.

But what about emerging companies or companies that have been establishing themselves for a few years but don't currently have a revenue stream. How do you estimate their growth?

Take a made up example. XYZ a tech company that develops phone apps. They've developed a few apps and they're starting to get some traction. Let's say everybody with a smartphone is a potential customer as it doesn't target a certain type of person. How would you estimate the growth off this company? Just because everybody could use their apps doesn't mean everybody is going to. Their growth could be huge (everybody in the world with a smartphone buys their apps)... or it could be zero.


What techniques do you use to estimate growth (other than using trends etc from historical data)? How do you 'measure anticipated growth' with no real data?


The post is intended to be about growth, not a debate on specific companies. But some examples in the NZ share market probably include (haven't had a chance to research these companies) Moa, NTL, DIL, Burgerfuel etc.

Happy investing
Nextbigthing

[Lizard]

Some quick thoughts:

1. Define growth

Sales growth? EBIT growth? NPAT growth? Dividend growth? Share price growth?
While generally most of them grow in the same direction, they don't grow at the same rate. Each one can be used in a different type of valuation ratio/model but the choice of which is most appropriate may depend on the type of business and the stage the company is at.

For your app company, given they are probably early stage and not yet profitable (or marginally profitable), sales growth is probably the easiest estimate - and probably need to be looking at the likely sales in 10 years time to get any feel of where the share price might go. This figure will likely be wildly different from reality, but then so will everyone elses estimates - and it is the average of everyones estimates that will end up driving the share price.

2. Techniques for different companies

The easiest companies to anticipate growth on are those that provide forecasts of the coming year, keep them updated and who have a record of achieving their forecasts - all you have to do is be the fastest to process new information from the company.

Some companies (only a few in NZ) meet a "cookie cutter" style business model that keeps EBIT margins fairly constant - these are the businesses whose costs are mostly variable and keep rolling out to new geographies. A fairly basic spreadsheet can be used to work out what growth rate these businesses can sustain by re-investing only what they make (i.e. no new capital). Dividends need to be allowed for. Long term changes in EBIT margins may need to be watched. New capital becomes a major fudge factor in any calculation of growth, as the price at which it may need to be raised cannot be predicted and there is a spiral-effect on price-value in one direction or other. Any cash reserves or debt need to be taken into account.

Companies with high fixed costs (e.g. power companies) need to be considered in terms of capacity use - which may take a bit of working through to find.

Some companies will be demand constrained, some constrained by cash and the capability for stable growth. Determine the constraint and work backwards from there.

3. How far out does actual growth matter?

For the majority of companies, analysts don't look much further than company forecasts and then create patterns in their forecasts, with growth tailing off to some long term "norm". In my view, 80% of what happens with a company share price over the next 12 months will depend upon the coming 6-12 month results - so if you invest on a "result-by-result" type basis, you only need to be have in mind where results are likely to be in 12-18 months time to feel comfortable buying and holding (at least until the next forecast or result).

[winner69]

why worry nextbigthing ..... no matter what you forecast you will invariably get it wrong

Have you seen any charts with hockey sticks in them ...... yes plenty of them I hear you say. Forecasts are always invariably optimistic

Put a series of forecasts together on one chart and you will see a set of blinds .... the visual effect of a series of hockey sticks. When one forecast is updated with the actual number and then the same assumptions applied you end up with another hockey stick

Look at some of the charts on this Rodney Ravings (he a good bloke that Rodney)
http://www.sra.co.nz/pdf/ChristmasRaving2011.pdf

Spooky eh .... all those guys earning zillions and they cant even forecast one number a year out

Did you know the baseline forecast wether people use for measuring their forecasting accuracy is 'tomorrows weather will e the same as todays" and in most cases that is more acccurate then what the foecasters come up with

[Snoopy]

Dividends are usually easy to assess based on historical data and industry type etc. This makes it easy to make factual rational decisions.

But what about growth? It's vital to increasing the shareprice and therefore vital for one to fully understand and estimate. But how does one work out growth when it's potentially subjective?

For companies with historical data, it seems reasonably straight forward. Take Mainfreight as an example. Plenty of data on their past performance and enough data about their expansion plans to estimate the revenue in a few years time. Easy.

But what about emerging companies or companies that have been establishing themselves for a few years but don't currently have a revenue stream. How do you estimate their growth?

From what I have heard and read over the years from Milford Asset management, who I think are quite well respected in this area, a lot of their estimates of value are done by benchmarking similar companies. For software that includes NASDAQ listed companies. I think this is probably a better idea that looking at a single tech company in isolation.

Take a made up example. XYZ a tech company that develops phone apps. They've developed a few apps and they're starting to get some traction. Let's say everybody with a smartphone is a potential customer as it doesn't target a certain type of person. How would you estimate the growth off this company? Just because everybody could use their apps doesn't mean everybody is going to. Their growth could be huge (everybody in the world with a smartphone buys their apps)... or it could be zero.

Exactly. This is possibly not the answer you want to hear. But I have only 24 hours in my day, and I think it important to spend those hours to best effect. Because of the difficulties you highlight, I choose to stay right out of the tech software scene. This absolutely guarantees that I will miss out on the 'next big thing'. But it also guarantees that I will miss out on the inevitable bust that eventually accompanies the 'next big thing'.

If you must chase a tech company I would suggest looking for companies that are established but feature tech as a 'sideline' arm. If you buy at the right time in the business cycle, the valuation should reflect the 'conventional' arm of the business and you get the tech bit thrown in for free. If the tech bit gets written off or closed down it doesn't matter to you, if you as an investor paid nothing for it.

An example of this is my investment in Scott Technology. The meat industry robotic system has not even contributed 1c on an eps basis over the ten years the system has been in development. Yet it is highly advanced and world leading, with probably a greater competitive advantage than anything that comes out of Xero or Diligent. You may think that is a funny comparison, but the automated meat processing system secret is not in the hardware but in the associated software. One day it will earn a profit so they say. But if it doesn't I am still getting my divvies from the 'boring' side of the business.

SNOOPY

[born2invest]

How do you intend to value to company if you have no idea what the growth will be (as your phone app company).

Why jump over 10 foot bars when you can step over 1 foot bars in an easy to understand and predictable business.

[nextbigthing]

How do you intend to value to company if you have no idea what the growth will be (as your phone app company).

Why jump over 10 foot bars when you can step over 1 foot bars in an easy to understand and predictable business.

Simple. If growth can be estimated with some degree of likelihood and certainty then you can jump the 10 foot bars with a reasonable degree of safety and get 10 times the rewards. Therefore the point of this thread is to encourage discussion about techniques people use to forecast growth potential seeing as it is so vital to company valuation.

NBT

[nextbigthing]

From what I have heard and read over the years from Milford Asset management, who I think are quite well respected in this area, a lot of their estimates of value are done by benchmarking similar companies.

SNOOPY

Thanks Snoopy. I guess benchmarking probably works very well for more 'traditional and stable' companies, perhaps the main banks for example. But I'm not sure how well it would work for a more volatile tech type company. Take Facebook as an example. It offered similar services to others eg bebo but ended up blitzing them all.

Your comment would suggest Milford are benchmarking off other larger breweries for MOA.

NBT

[Snoopy]

Thanks Snoopy. I guess benchmarking probably works very well for more 'traditional and stable' companies, perhaps the main banks for example. But I'm not sure how well it would work for a more volatile tech type company. Take Facebook as an example. It offered similar services to others eg bebo but ended up blitzing them all.

Your comment would suggest Milford are benchmarking off other larger breweries for MOA.

NBT, as a rule if I am looking for growth assets I am very keen to look for those assets at a reasonable price. If you form a view that a business is high growth, I have found you can rationally justify paying a very high price which leaves you in big risk territory when growth is only 50% of what you thought it would be.

Facebook, IIRC has only just got back to its issue price. While it has been a great investment for its founders it has been somewhat less stellar for IPO investors.

When I suggested benchmarking, I meant benchmarking against companies in a similar stage of development. Milford might be benchmarking MOA against the timeline of what happened with 42 below (now taken over) for example. They definitely would not be benchmarking MOA against established breweries.

SNOOPY

[nextbigthing]

So can someone shed some light on the following as an example of pricing growth...

Take mainfreight. Already currently earning 66cps ÷ $10.20 = 6.5% return. New offices opening in new countries around the world. Revenue growth when Europe picks up. Ie some reasonable future growth there.

Now take ATM. Earning 0.74cps ÷ $0.70 = 1% return. Growth has quite a solid potential with sales to China just starting up, possibility of U.S etc.

Given this, just to come up to where mainfreight is already at, ATM would need to increase eps 6.5 times AND maintain the current shareprice. That's a lot of growth just to match MFT and return 6.5% which isn't stellar.

This means they would need to maintain what they've achieved in Australia and replicate it in China, UK, Ireland and the USA to even greater levels.

The positive being they may do this and even more.
There's the risk this doesn't happen and they only ever return say 4%

My point being with MFT you're buying a more or less guaranteed 6.5% already, but still with the highly likely possibility of growth added in for free, which seemingly has far less risk.

So how do you factor this potential growth into the ATM shareprice and justify it against something like MFT?


Disc - own MFT, currently researching and considering ATM

[Snoopy]

So can someone shed some light on the following as an example of pricing growth...

Take mainfreight. Already currently earning 66cps ÷ $10.20 = 6.5% return. New offices opening in new countries around the world. Revenue growth when Europe picks up. Ie some reasonable future growth there.

Now take ATM. Earning 0.74cps ÷ $0.70 = 1% return. Growth has quite a solid potential with sales to China just starting up, possibility of U.S etc.

Given this, just to come up to where mainfreight is already at, ATM would need to increase eps 6.5 times AND maintain the current shareprice. That's a lot of growth just to match MFT and return 6.5% which isn't stellar.

This means they would need to maintain what they've achieved in Australia and replicate it in China, UK, Ireland and the USA to even greater levels.

China and the UK are much bigger markets than Australia. So if the population of the UK is 5x that of Australia and the Australian market share is 6%, then ATM will gain the same cashflow as from Australia by gaining just 1.2% of the UK milk market. If ATM get 6% of the UK milk market then revenue goes up by 500%. OK I am talking cross purposes here, because the UK market is being tackled via a joint venture so the two markets are not directly comparable from a business model perspective. But I hope you get the idea that a relatively small market share in a big new market can have large effects for ATM. Of course actually gaining 1.2% of the UK market might be easier said than done.

As ATM gets larger ultimately the PE ratio will come down, as the forecast of potential revenue growth in the future to actual revenue now reduces.

The positive being they may do this and even more.
There's the risk this doesn't happen and they only ever return say 4%

My point being with MFT you're buying a more or less guaranteed 6.5% already, but still with the highly likely possibility of growth added in for free, which seemingly has far less risk.

So how do you factor this potential growth into the ATM shareprice and justify it against something like MFT?

Mainfreight is a very well managed company, but the incremental growth they are likely to achieve relative to current revenues is far less than ATM. This is why the PE for MFT is lower.

SNOOPY