Warren Buffett (Trades, Portfolio) once likened valuation to Aesop’s fable, “a bird in the hand is worth two in the bush.” The trick though, he tells us, lies in figuring out how many birds are in the bush, when they will appear, and our certainty of the birds’ existence. Let’s take a closer look at a key valuation input, growth rates, and see if we can better determine how many birds are in the bush.
Growing Pains
In building a discounted cash flow model, one must decide on a growth rate. Where do we start? New York University finance professor Aswath Damodaran offers up three possibilities; historical numbers, managers and analysts. However, he says these sources are laced with problems. Historic growth rates may not be sustainable, managers are sometimes optimistically biased, and analysts can be focused on the short term. Instead, Damodaran points to the company itself.
“For a company to grow over time, it’s got to reinvest a significant portion of earnings back into the business and it’s got to reinvest them well.” - Damodaran, Estimating Growth
To find out just how well a company is doing this job, we look to retention ratios and returns on equity. Retention ratios simply tell us how much net income management is reinvesting in the company and return on equity measures how well it is using these funds. A retention ratio of 60% and a ROE of 20% leads to an expected growth rate of 12% -- (60% x 20%). This is the growth rate we should use for valuation, according to Damodaran.
Fluid Trains
Turning to the real world, we find that pump maker Graco Inc. (GGG) acheived a median ROE of 45.9% and a median retention ratio of 66.6% over the last 10 years. This leads to a growth rate of 30.7%. In another example, the train product-maker Westinghouse Air Brake Technologies Corp. (WAB) delivered a median ROE of 20.3% and a median retention ratio of 97.8% over the past 10 years, giving us a growth rate of 19.9%.
This method still relies on history, but it also avoids a big problem: one-year anomalies. Graco, for instance, had a retention ratio of nearly 80% in 2015, a significant increase over its historic levels. A check of the company’s dividend policy, however, shows that the company will retain about 60% of its earnings in 2016, a reversion closer to its historic median.
The Bottom Line
Determining growth rates for valuation purposes is a nuanced affair: history may not repeat, management can be biased, and analysts may be short-sighted. Aswath Damodaran tells us to look to the company itself and use retention ratios and returns on equity to tell how much and how well management is reinvesting earnings. This gives us a meaningful growth rate and although it is still necessary to navigate the waters of cash flows and discount rates for intrinsic valuation, we are well on our way to figuring out how many birds are in the bush.
Disclosure: The author owns shares of Westinghouse Air Brake Technologies Corp (WAB, Financial).
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