Growth rates, P/E, and PEG

Investment Analysis Clubs Saul’s Investing Discussions
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Differences of opinion make a market, and a message board. So I’ll paraphrase Mr. Buffett:

Growth rates, P/E, and PEG (whatever version of PEG used) have nothing to do with valuing a business. They only give you hints as to the amounts and timing of future cash flows.

P/E and PEG are both silent as to what financing is needed to produce the “E” in P/E, and whether that financing creates value or destroys value. Growth rates only tell how fast that value is being created or destroyed. A business can grow earnings just by borrowing more money, even if the cost of that borrowing is greater than the return generated by the additional capital. P/E and PEG are both silent on management’s ability to allocate capital, on evaluating the competitive position of the business, on understanding the underlying economics of the business, and many other drivers of future cash flows.

BOTTOM LINE: Growth rates, P/E, and PEG are attributes of value, not determinants of value.

Pages 13-14 of Mr. Buffett’s 2000 Annual Letter to Shareholders has a classic section on valuation. It’s worth the read.

http://www.berkshirehathaway.com/letters/2000pdf.pdf

As a relative newcomer to this board, I hope this is received in the spirit that it is given: sharing ideas and stimulating discussion.

Thanks,
Ears

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A business can grow earnings just by borrowing more money, even if the cost of that borrowing is greater than the return generated by the additional capital.

Hi Ears,

Thanks for the interesting thoughts and great link.

I am probably the worst investor in the world – well, no, actually there is one man in Marseilles – so I am probably missing the obvious as usual.

But if a company borrows money, isn’t the cost of that borrowing reflected (as interest and other expenses) in earnings? So if the cost of borrowing is greater than the return generated by the borrowed funds, wouldn’t the rules of accounting reflect that, so that earnings are reduced by those high borrowing costs? (Obviously, revenue is a different story.)

I.e., if I were a good enough investor to have any confidence at all in my thinking, I would tentatively and in a very constructive, collegial way disagree with the above statement. Lacking that confidence, I am just asking for further insight.

In a similar vein, if capital is raised in the form of equity issuances, would not a similar analysis lead to the conclusion that EPS adequately handles this concern?

Of course, I imagine that the accounting rules allow for holes in mapping costs of generating earnings to the amount of earnings – for example, how does one handle depreciation and amortization of capital expenditures? – but probably cash flow analysis has similar issues, right? And, given the massive attention given to financial accounting, are those potential holes really large enough to worry about to the extent suggested by the above italicized statement?

My point is a narrow one. I very much agree that earnings (and for that matter cash flow) metrics are informative but by no means dispositive as to value. For example, a regional themed restaurant (CHUY, for example) may be very successful in its home region, leading to rapid growth metrics, but may face a very difficult transition to a national stage – making the existing growth metrics misleading, at least potentially.

Thanks for your many recent contributions to this excellent board!

Rich

CED

Who recently gained the dubious honor of being the first human to fail a Turing test . . . .

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I am probably the worst investor in the world

Actually, the worst cease to be investors since they have lost all their money.

But if a company borrows money, isn’t the cost of that borrowing reflected (as interest and other expenses) in earnings?

The interest is reflected as a current expense, but the obligation to repay ends up on the balance sheet … and eventually, one has to repay.

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Hi Rich,

I am probably the worst investor in the world – well, no, actually there is one man in Marseilles…

C’est moi.

But if a company borrows money, isn’t the cost of that borrowing reflected (as interest and other expenses) in earnings? So if the cost of borrowing is greater than the return generated by the borrowed funds, wouldn’t the rules of accounting reflect that, so that earnings are reduced by those high borrowing costs?

Interest is tax deductible. That’s one advantage of taking on debt for corporations. So to use a far-fetched example: say a company had $10M in cash earning 2%. Earnings in year 1 on the $10M was $200K. In year 2 they borrow $2M at 3% interest = $60K, but if their tax rate is 40% then $24K is deductible so only $36K falls to the bottom line. In year 2 their capital is the original $10M plus 200K retained earnings from year 1 plus $2M borrowed = $12.2M. In year 2 they earn $12.2M * 2% = $244K minus $36K after tax interest = $208K earnings, which is a 4% gain from year 1.

When I was first starting out in investing I used to wonder why corporations would take on debt to pay dividends. Later I found out it was because of the tax benefit of interest. Same with a home mortgage – your effective interest rate is less if you can deduct the interest.

In a similar vein, if capital is raised in the form of equity issuances, would not a similar analysis lead to the conclusion that EPS adequately handles this concern?

Here’s another overly simplified example. Say a company has $10M in equity and 100K shares and earns 2%, so earnings the first year are $200K divided by 100K shares = $2.00 per share. In year 2 the company issues 10K new shares at $100 per share = $1M in new capital and adds that to the $10M start plus $200K retained earnings = $11.2M. Earnings in year 2 are $11.2M * 2% = $224K divided by 110K shares = $2.04 per share. Earnings per share have grown 1.8% just by issuing some ‘free’ equity.

It wasn’t until later in my investing life that I realized equity has a ‘cost’, which is going to be greater than the cost of debt because of the additional risk where debtors are first in line.

Check my math – I did this pretty quickly. Hope this helps.

Thanks,
Ears

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Rich,

I wish I had an edit button. That debt example I just gave you is terrible. Please ignore it because it will only confuse things. I really need to use an example with incremental debt. I will try to come up with something in the morning.

Thanks,
Ears

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Thank you, Ears!

The tax point you raise is interesting in its own right – it is, I guess, a policy-based incentive pushing a company toward debt financing as opposed to equity financing (and casts debt in a somewhat more favorable light from a company evaluation standpoint as a result, perhaps).

Which is maybe a different discussion, but worth thinking about nonetheless.

Best,

Rich

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Hi Rich,

Apologies again for trying to hurry through an example last night without giving it any thought. Here’s one that I hope will give you a better idea. First I’m going to set up a base case. Then I’ll show the effect of borrowing.

BASE CASE

Let’s say I wanted to start a business with $10M of my own capital. I hire my cousin to manage it. I tell him my only requirement is that he earn at least 10% every year on my investment. He doesn’t have to give me any of the cash earnings right away – he’s free to reinvest it in the business as long as that reinvestment earns 10%.

So after three years here is how it would look:


       Div        Capital    Return%   Earnings$     Shares        EPS     Growth
        ---     ----------    -------   ---------    -------     ------     ------
Year 1    A     10,000,000      10.0%   1,000,000    100,000      10.00

Year 2    A     10,000,000      10.0%   1,000,000    100,000      10.00
          A      1,000,000      10.0%     100,000    100,000       1.00
                ----------              ---------                 -----
                11,000,000      10.0%   1,100,000    100,000      11.00      10.0%

Year 3    A     10,000,000      10.0%   1,000,000    100,000      10.00
          A      1,000,000      10.0%     100,000    100,000       1.00
          A      1,000,000      10.0%     100,000    100,000       1.00
          A        100,000      10.0%      10,000    100,000       0.10
                ----------              ---------                 -----
                12,100,000      10.0%   1,210,000    100,000      12.10      10.0%

The business has one Division – Division A. In the first year Division A earned $10M * 10% = $1M. It has 100,000 shares so $10/share in earnings. In year 2, Division A earned 10% on the original $10M plus 10% on the retained earnings of $1M from year 1 for a total of $1.1M in earnings = $11 per share. Growth in earnings is 10%. In year 3, Division A continues to earn 10% on its original capital and 10% on the retained earnings. Growth is still 10%.

BORROWING CASE

Instead of the Base Case described above, suppose my cousin said in year 2 that he wanted to borrow some capital from the bank to invest in an exciting new venture – Division B. He tells me the results might not look good at first but to be patient because he needs to build market share. So I say okay, and he takes out a loan for $10M at 3% interest. His initial return on the $10M is going to be 4%, so his net return after interest is 1%. (For this example we will ignore the tax benefit). In year 3 he borrows an additional $14M.

After 3 years this is how it would look:


        Div        Capital    Return%   Earnings$     Shares        EPS     Growth
        ---     ----------    -------   ---------    -------     ------     ------
Year 1    A     10,000,000      10.0%   1,000,000    100,000      10.00

Year 2    A     10,000,000      10.0%   1,000,000    100,000      10.00
          A      1,000,000      10.0%     100,000    100,000       1.00
          B     10,000,000       1.0%     100,000    100,000       1.00
                ----------              ---------                 -----
                21,000,000       5.7%   1,200,000    100,000      12.00      20.0%

Year 3    A     10,000,000      10.0%   1,000,000    100,000      10.00
          A      1,000,000      10.0%     100,000    100,000       1.00
          A      1,000,000      10.0%     100,000    100,000       1.00
          A        100,000      10.0%      10,000    100,000       0.10
          B     10,000,000       1.0%     100,000    100,000       1.00
          B        100,000       1.0%       1,000    100,000       0.01
          B     14,000,000       1.0%     140,000    100,000       1.40
                ----------              ---------                 -----
                36,200,000       4.0%   1,451,000    100,000      14.51      20.9%

My cousin has been able to grow earnings 20% per year instead of 10% per year due to the borrowing. Notice he has more earnings at the end of year 3 than in the base case. BUT…look at the return on investment – it dropped in year 2 from 10% return to 5.7% return. In year 3 it dropped from 5.7% to 4.0%. If nothing changes, every year that return will drop even though earnings are growing. That’s because my cousin is playing a shell game of sorts. He has to keep borrowing more and more at unattractive rates of return in order to keep up the earnings growth. He is destroying value. As long as I believe his rationale – that he is building market share and eventually the rate of return will go up – and as long as the banks keep lending us money, then he can keep doing this for a while. Unfortunately, often the bubble bursts. The promised rates of return never materialize. The company is no longer able to borrow. When that happens, that growth rate will drop like a rock. We still have to pay off the loans. Will this be an attractive business to sell with $24M in debt and a 4% return on investment?

It’s a contrived example – hope it helps though. Be glad to discuss further.

Thanks,
Ears

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The borrowed money is not capital, it’s a liability. To find out if the borrowing was worth while, close both businesses (with and without borrowing), cancel all debts, and figure out the IRR of both scenarios.

Denny Schlesinger

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The borrowed money is not capital, it’s a liability.

Hi Denny,

While it’s true that debt is a liability on the balance sheet, it’s also true that it’s a form of capital financing for the firm…

debt + equity = invested capital

We are looking for the return on invested capital (the infamous ROIC).

Thanks,
Ears

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It’s a contrived example – hope it helps though. Be glad to discuss further.

Hi Ears,

That is an outstanding example and quite clearly explains your point. And it actually does not seem at all unrealistic to me, except the part about trusting one’s cousin.

Growth in earnings in this case is in significant part attributable to growth in borrowing, which (i) might well be unsustainable, leading to a “pay the piper” time of much-reduced growth in the future and (ii) shows that growth can appear in different contexts, with radically different implications for valuation.

Thank you for taking the time to do this. I have learned something today, which, for a very old dog, makes it kind of a good and unusual day!

Best regards,

Rich

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Ears,

Thanks!

That took some time, a rec is not enough. Very interesting excercise

Gator

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Hi ears, sorry, I’ve just gotten around to reading this thread. It seems to me after a careful reading that the point you are really making here is that Debt matters. This seemed so clearly to be the essence of your example that I was surprised that you didn’t seem to emphasize it as a primary consideration of what you were talking about.

In my FAQ “credo” I mention that I avoid companies with lots of Debt if possible: Absence or near absence of debt is important, except in companies where debt is part of their business model, where it’s sort of excusable. (I do have some companies with debt loads due to acquisitions, like WAB, but I have limits: Here’s a paraphrase of I posted to the guys who are enthusiastic about GBX: Don’t you guys think it should be a concern that GBX’s Debt is over three and a half times its Cash (250% more Debt than Cash)… WAB has about 23% more debt than cash too, which, while enormously less, is still a little worrisome.) I, personally, couldn’t imagine investing in a company with three and a half times as much Debt as Cash.

What you seem to be saying is that taking on a lot of debt can produce pseudo profits, but you are stuck with all this money you have to pay back, and the danger that if times turn bad, you can’t pay it back. I agree totally.

Saul

For FAQ’s and Knowledgebase
please go to Post #7062

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Ears, I thought some more on this and perhaps you are playing a shell game on us without realizing it.

The “capital” you invested is just 10,000,000, no matter how much your cousin borrows. At any time your cousin can pay back the borrowed money and will have made more money than you. In other words, at the end of year 2 he could pay back the 10,000,000 he borrowed and have your original capital and the 1,200,000 he earned that year (or $12 per share).

For a simplified example, here are the one year results without borrowing:


    Div           Capital    Return%    Earnings$     Shares        EPS     
        ---     ----------    -------   ---------    -------     ------    
Year 1    A     10,000,000      10.0%   1,000,000    100,000      10.00

Now, for a simple comparison, let’s say your cousin started borrowing this first year. So he’s working with your capital and 10,000,000 of borrowed capital as well


                   Capital    Return%    Earnings$    Shares       EPS 
Year 1    A     10,000,000      10.0%   1,000,000    100,000      10.00
          B     10,000,000       1.0%     100,000    100,000       1.00
                ----------              ---------                 -----
                20,000,000              1,100,000    100,000      11.00

At the end of the year he pays back the borrowed capital. You still have your 10,000,000, and you have 1,100,000 your cousin made instead of the “measly” 1,000,000 you would have made without the borrowing. He made 11% on your money while you would have made just 10%. Your cousin is a genius! … :wink:

Saul

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Saul, your’s is the same objection I posted (7507) when I said:

The borrowed money is not capital, it’s a liability. To find out if the borrowing was worth while, close both businesses (with and without borrowing), cancel all debts, and figure out the IRR of both scenarios.

to which ears responded:

While it’s true that debt is a liability on the balance sheet, it’s also true that it’s a form of capital financing for the firm…

debt + equity = invested capital

We are looking for the return on invested capital (the infamous ROIC).

I didn’t want to pursue the matter further but the real question in my mind is how much predictive value these various “measures” actually have in the real world of business and investing. I’m not picking on ears, I have the same objection to PEG, your 1PEG, DCF and all sorts of ratios. The more complex they are the less I like them. In One Up On Wall Street one finds out that Peter Lynch uses these measures sparingly. In more general terms the question is whether drilling down into the numbers yields more useful information that, say, looking at price charts. In both cases we are driving by looking through the rear view mirror. You might have noticed that I have a preference for charts even though prices have gotten a bad rap from glib statements like “A cynic is a man who knows the price of everything and the value of nothing.” [Oscar Wilde]

Denny Schlesinger

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Hi Saul,

Thanks for your two responses. I’ll try to address both here.

It seems to me after a careful reading that the point you are really making here is that Debt matters…What you seem to be saying is that taking on a lot of debt can produce pseudo profits, but you are stuck with all this money you have to pay back, and the danger that if times turn bad, you can’t pay it back.

No, that’s not the point. If that’s what you got from it then I didn’t explain very well. Debt is only a minor character in this story.

The point of the example is that growth in earnings tells you nothing about value. Growth in earnings can be good or bad. Some people ask, “How can growth in earnings be bad!?”. Well, growth can be bad when a manager is growing earnings but is destroying value by investing in projects that have unattractive rates of return. The example showed that my cousin was able to grow earnings by 20% per year but was only making a 1% return on the incremental capital invested, a very unattractive return. He was destroying wealth, and the growth only made it worse because he was destroying wealth at a faster pace each year.

At the end of the year he pays back the borrowed capital. You still have your 10,000,000, and you have 1,100,000 your cousin made instead of the “measly” 1,000,000 you would have made without the borrowing. He made 11% on your money while you would have made just 10%.

Sure. In fact he could do this for several years. Again, this wasn’t the point. The point is that every year he would have to inject more and more capital to keep up that earnings growth because he was getting such a poor rate of return on that new investment. Thus, every year the value of the firm would be diminishing, even though earnings were growing!

Hope this helps. I’d be happy to work through a few more examples with you or have further discussion about some of these points.

Thanks,
Ears

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At the end of the year he pays back the borrowed capital. You still have your 10,000,000, and you have 1,100,000 your cousin made instead of the “measly” 1,000,000 you would have made without the borrowing. He made 11% on your money while you would have made just 10%.

The point is that every year he would have to inject more and more capital to keep up that earnings growth because he was getting such a poor rate of return on that new investment. Thus, every year the value of the firm would be diminishing, even though earnings were growing!

Sorry, Ears, I don’t see it! At the end of the year he paid back what he borrowed. The value of the firm is NOT diminished. It’s what you started with plus what he earned. Again: He paid back the borrowed money! You have the same $10,000,000 you started with, PLUS what he earned. Even though he only made 1% on the borrowed money, that was more than you would have made without borrowing. ($1,000,000 plus 100,000 is more than $1,000,000 without 100,000.) He made 11% on YOUR money, the money you put in. You would have made 10%. Sure if he wanted to make 11% again next year, he’d have to borrow again next year, but so what, as long as he’s making a positive return.

Saul

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Sure if he wanted to make 11% again next year, he’d have to borrow again next year, but so what, as long as he’s making a positive return.

Except, for earnings growth, he needs to target 12.1M the next year, so he is going to have to borrow twice as much to meet that goal.

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--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- by the way, as presented my conclusions are obviously correct, so don’t waste time trying to disprove them…but I made an unwarranted assumption you haven’t noticed yet. See if you can find it.--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Saul

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tamhas, because your goal is to make 11% on a larger amount doesn’t mean the value of the company is diminished. It’s just that you are setting high goals. The value of the base company is not diminished.

This is a riddle, by the way.

:wink:

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He made 11% on YOUR money, the money you put in. You would have made 10%. Sure if he wanted to make 11% again next year, he’d have to borrow again next year, but so what, as long as he’s making a positive return.

Hi Saul,

I understand why you are not getting it. You are focusing on one year. If we look at just one year then we are not talking about annual growth in earnings. By definition earnings growth requires the difference between year and another.

The point is about growth, and how growth is related to investment. In order to understand that we need an example that shows earnings growth and the investment needed to fund that growth – from year 1 to year 2, and then from year 2 to year 3. That was the example I used, but perhaps together we can come up with another one that will be clearer.

Thanks,
Ears

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