How Do I Measure My Company’s Long-Term Growth?
Measuring long-term growth is an essential aspect of the valuation of a business. Long-term strategic health demonstrates a company’s ability to sustain its current level of operation and find growth opportunities.
Several factors can influence these capabilities, such as new technologies and changing customer preferences. Sometimes projecting this long-term growth can be difficult, so specific qualitative metrics and milestones can be used. The stability of markets in the sector can also be a growth factor. Regulated markets may be stable, but growth is limited. Expanding industries typically offer better long-term growth opportunities.
Growing revenue is always a good thing, but it doesn’t mean future growth is guaranteed. Sustained growth depends on expanding a business’s ability to continue producing goods or providing services. There are several ways that long-term growth can be quantified.
Return on Equity
To measure growth, one of the first things you can do is look at the company’s return on equity (ROE). ROE is defined as the profit a business makes as a percentage of stockholders’ equity, which can be found on the company’s balance sheet under stockholders’ equity (or in the annual report). At the beginning of the year, divide the net earnings by the stockholders’ equity and then multiply by 100 to arrive at the ROE percentage. By measuring ROE, you can get a window into how much investment will pay off. But it’s not always that simple. For example, some earnings may be paid out as dividends rather than being reinvested, and some may be needed for maintenance and upkeep, so they do not contribute to growth. Also, keep in mind that a high ROE isn’t necessarily always a good thing. It can indicate issues, such as excessive debt or inconsistent profits.
One of the simplest ways to measure growth is to follow what recognized financial analysts are saying. They take deep dives into companies and then predict how well they think the company will perform in the next few years. While they are highly educated in doing this, they tend to be highly optimistic and not necessarily reliable or realistic.
The sustainable growth rate is the expectation that company growth, in the long run, will equal the rate at which stockholders’ equity grows. It is the maximum rate at which a business can grow without more debt.
The sustainable growth rate can be calculated as ROE x (1 - dividend payout ratio).
The ROE ratio is adjusted for any dividends that are paid out because only retained earnings (Net Income - Dividends) can be used to grow the company.
Historical Earnings Per Share (EPS) Growth
Another way to gauge a company’s future growth is by looking at how quickly it has grown its earnings over the past ten years. EPS refers to the earnings available to each shareholder (per share).
The formula for EPS is: EPS = (Earnings) / (Shares Outstanding).
However, historical earnings growth cannot simply be applied to future years. As a company grows, it becomes more difficult to sustain a high growth rate. As a result, growth rates can be expected to decrease over time. This is sometimes referred to as the Law of Large Numbers, which means that a large entity growing rapidly cannot sustain that growth pace forever. This is often seen with billion-dollar blue-chip corporations.
Sometimes also called the retention rate, the plowback ratio is the percentage of net earnings that a business reinvests after earnings are paid out. For example, a business with an ROE of 8% can grow at 8% if it reinvests all of its net profits. But many companies pay out some of their net earnings to stockholders in dividends. If a company pays 30% of its net earnings to stockholders as dividends, it leaves 70% of the net earnings to be reinvested, making the plowback ratio 70%. Younger companies usually have higher plowback ratios because faster-growing firms are more focused on business development. More established businesses do not need to rely on reinvesting profits to expand operations.
Free Cash Flow (FCF) Per Share
Many of the valuation models that are used on publicly traded stocks rely on the calculation of FCF per share. This is because stronger free cash flow leads to stronger future earnings. FCF is an accurate representation of actual cash flow available to shareholders at a given time. Earnings do not represent the proper cash flow of a company because the accounting is adjusted for tax purposes and to show better financial results of the business operations from year to year. As long-term investments for future growth, large capital expenditures can impact short-term cash flow but do not necessarily mean poor operating performance. That’s why depreciation was invented.
Free cash flow is thought to be a more accurate measure than earnings because it shows how much cash flow investors are expected to receive. Some companies can have solid earnings and need continuous capital spending to keep up long-term operations. This can substantially limit the actual cash flow available to be given back to shareholders now and down the road.
FCF is often used to indicate how a company is likely to perform based on how management foresees future demand and how it is being invested in working capital and capital expenditures.