Yesterday while speaking with our new contributor, Aaron Horvitz, the topic of calculating growth came up.Â The calculation of a forecasted growth rate is one of the most significant variables in any company valuations.Â Growth is often miscalculated, leading to an inaccurate calculation of intrinsic value.
We believe that growth is best forecasted using historical data from the company at question.Â Since the variable is so important to the calculation, it is important for the intelligent investor to avoid any speculation that comes from using subjective judgment to simply forecast what a company may achieve in terms of growth in the future.
Previously we had been calculating growth by taking an average of the annual growth in net income.Â Aaron suggested we take the approach of a Compound Annual Growth Rate, which eliminates the statistical error inherent in a simple average.Â For example, if a company grows earnings from $10 to $20, there is a 100% increase.Â If the following year the earnings drop back to $10, it shows a 50% decrease.Â Using a strict average of the two year’s growth would give an average growth of 25% per year.Â However, the actual growth achieved by the company would be 0% using a compound annual growth rate method.
So the suggestion from Aaron was to use the earnings per share 5 years ago and the current earnings per share to calculate the growth over the 5 year period, then divide that by 5 to get the average per year.Â This would be a very good approach except for the fact that you are stuck with the possibility of using years that abnormally reflect the company’s performance.Â Perhaps the company’s earnings were affected by a down year in the business cycle.
I decided to compensate for cyclical problems the same way we do with our calculation of PE (see our methods) – by using a weighted average of the previous 5 years of earnings per share.Â This allows us to gauge the growth rate that has been historically achieved without worrying about cyclical changes in the annual performance.
As a result of this change, a few of our recent analyses and valuations have been changed.Â
What other methods of determining growth do our readers use?Â What do you think of our method?Â Do you think we’re on the right track or do you have a suggestion for us to improve the calculation even further?Â Let us know by leaving a comment below.Â Your thoughts are always appreciated.