Determinant 1 : The Expected Growth Rate

Determinant 1 : The Expected Growth Rate

Most people don’t realize the implications of compound growth on financial decisions. It is often said that the Indian who sold Manhattan Island in 1626 for $24 was rooked by the white man. In fact, he may have been an extremely sharp salesman. Had he put his $24 away at 6 percent interest, compounded semiannually, it would now be worth over $50 billion, and with it his descendants could by back much of the now-improved land. Such is the magic of compound growth.

Similarly, the implications of various growth rates for the size of future dividends may be surprising to many readers. Growth at a 15 percent rate means that dividends will double every five years (a handy rule for calculating how many years it takes dividends to double is to divide 72 by the long-term growth rate. Thus, if dividends grow at 15 percent per year they will double in a bit less than five years (72 + 15).

The catch (and doesn’t there always have to be at least one, if not twenty-two?) is that dividend growth does not go on forever. Corporations and industries have cycles similar to most living things. There is, for corporations in particular, a high mortality rate at birth. Survivors can look forward to rapid growth, maturity, and then a period of stability. Later in the life cycle, companies eventually decline and either perish or undergo a substantial metamorphosis. Consider the leading corporations in the United States 100 years ago. Such names as Eastern Buggy Whip company, La Crosse et Minnesota Steam Packet Company, Lobdell Car Wheel Company, Savanna and St.Paul Steamboat line, and Hazard Powder Company, the already mature enterprises of the time would have ranked high in a Fortune top 500 list of that era. All are now deceased.

Knowing is not enough; we must apply. Willing is not enough; we must do (Johann Wolfgang von Goethe)

Look at the industry record. Railroads, the most dynamic growth industry a century ago, finally matured and enjoyed a long period of prosperity before entering their recent period of decline. The paper and aluminum industries provide more recent examples of the cessation of rapid growth and the start of a more stable, mature period in the life cycle. These industries were the most rapidly growing in the United States during the 1940s and early 1950s. By the 1960s they were no longer able to grow and faster than the economy as a whole. Similarly, the most rapidly growing industry of the late 1950s and 1960s, the electronics industry, had slowed to a crawl by the 1970s.

And even if the natural life cycle doesn’t get a company, there’s always the fact that it gets harder and harder to grow at the same percentage rate. A company earning $1 million needs increase its earnings by only $100,000 to achieve a ten percent growth rate, whereas a company starting from a base of $10 million in earnings needs $1 million in additional earnings to produce the same record.

The nonsense of relying on very high long-term growth rates is nicely illustrated by working with population projections for the United States. If the populations of the nation and of California continue to grow in their recent rates, 120 percent of the United States population will live in California by the year 2035. Using similar kinds of projections, it can be estimated that at the same time 240 percent of the people in the country with venereal decease will live in California. As one Californian put it on hearing these forecasts. “Only the former projections make the latter one seem at all plausible.”

As hazardous as projections may be, share prices must reflect differences in growth prospects if any sense is to be made of market valuations. Also, the probable length of the growth phase is very important. If one company expects to enjoy a rapid 20 percent growth rate for ten years, and another growth company expects to sustain the same rate for only five years, the former company is, other things being equal, more valuable to the investor than the latter. The point is that growth rates are general rather than gospel truths. And this brings us to the firm-foundation theorists’ first rule for evaluating securities:

Rule 1: A rational investor should be willing to bay a higher price for a share the larger the growth rate of dividends.

To this is added an important corollary:

Corollary to Rule 1: A rational investor should be willing to pay a higher price for a share the longer the growth rate is expected to last