Rule #1 Finance Blog

With Investor Phil Town

TOO MUCH GROWTH?

A question for Phil Town

from Mark in Falls Church, VA:Phil_town_120

I just had a quick question about upper boundries. In Phil Town's book you often repeat the necessity of moat numbers remaining at or above 10% but do you believe there to be any moat numbers that are too high? I've heard that in general 25% earnings growth is about the highest one should allow before things get scary.

Can there be too much growth?

Oh yes oh yes there can be too much growth.  The laws of compounding prove it.

If a business is growing at 50% a year, say, in ten years its earnings
per share will be almost 60 times bigger than now.  Presumably its
revenue and equity and cash growth will keep pace (since it's a
wonderful business, right?), so everything is 60 times bigger.

Let's take Google for an example.  It's on track this year to have sales
of $10 billion.  It's growing revenue at 70% a year.  If it continued to
do that, how big would the sales have to be in ten years?  $600
billion.  Hmmmm. 

Exxon, the biggest business in the world, has sales
of $390 billion today, and in ten years could be over $1 Trillion in
sales.  So maybe Google could get there.  But doesn't that seem a bit
large for a business that isn't selling oil?

Yahoo got into this sort of logical inconsistency back in 1999.  At
that point, given the expected growth rate that it had to have to be
worth what your fund manager was paying for it, by 2010, Yahoo would
have had to have revenues that exceed the gross national product of the
entire United States… or something crazy like that.

Point is, expecting huge growth rates to continue indefinitely is a
form of "irrational exuberance" which is best avoided.  Remember that
the value of understanding the Meaning of the business as well as its
Moat is to be able to make a reasonably accurate projection of the
future.  If you can't, then you really can't price the business, and if
you can't do that, then you don't know what to pay, do you?

You are right, Mark.  25% is a heck of a high rate of growth to sustain
indefinitely.  Few businesses do it.  If you find yourself convinced
that the historical rate of growth is higher than that and if the
average analyst agrees with you (remember that we use the lower of the
analyst estimate or historical or our own) then I would be a bit
worried that I didn't really know the business and industry well
enough.

It isn't a bad idea to drop the growth rate to 25% on businesses like
Google and see how they price out.  In Google's case, a 25% growth rate
and a 50 PE will still put the Sticker at $900 and the MOS right at
$450. 

Of course, Google is a bad example because it is definitely a
Risky Biz stock with too little history to determine its growth rate
and too technical a future to be certain where it will end up.  But it's
in my portfolio with these numbers.

Now go play. Phil Town