The value of a company lies entirely in the future, and it is our job to predict that future with a degree of accuracy and confidence. To choose a growth rate, we must delve into the inner workings of a company and see how quickly it will grow internally.
Enter CROIC.
By the way, Babui does a good job of predicting the future as he anticipated today’s post.
Cash From Invested Dollars
CROIC tells us how effectively our company can generate cash from money invested in the business. (If you are new to CROIC, check out What The Heck Is CROIC?) Over the long haul, businesses will grow at the rate of CROIC. That is, your company will grow at the rate at which it can turn invested dollars into excess cash-and reinvest those dollars for excess cash.
A Growth Example
If your company has $1,000 of invested capital and generates $100 of free cash flow (FCF) this year, it has earned a CROIC of 10% ($100/$1,000). Now what? That FCF will be reinvested in the business, kicking the invested capital up to $1,100. On that $1,100, let’s assume that your company can continue to kick off CROIC at 10%-generating $110 of FCF for the next year.
And so on and so forth forever. Now, in the above example, your company is going to grow at roughly 10% for the long-term. In some years, it may slash expenses or increase capital expenditures giving it a higher or lower CROIC (and higher or lower FCF growth) in certain periods. Still, at the end of the day, your company will grow at roughly 10%.
High CROIC Forever?
At the annual meeting, Mohnish Pabrai talked a bit about returns on invested capital and growth rates. To paraphrase, he explained that, no matter how quickly the company was growing cash, it couldn’t do so at high rates forever. The reason: the power of compounding.
If a company had a CROIC of, say, 35% forever, it would double in size every 2.3 years. But that can’t go on forever for two reasons:
- Eventually (and sooner rather than later), that company would be larger than the global economy-an impossibility to say the least; and,
- That company would have to constantly reinvest its excess cash at 35% in perpetuity-a feat that even Buffett himself can’t do at his size.
History: Will It Repeat?
Take a look at Google. Now, there isn’t enough of a history there for me to make an honest assessment of its value and, because it is in a rapidly changing industry, I would normally pass anyways. Still, let’s use it as an example.
In its short history as a public company, Google’s FCF has grown from $219 million in 2003 to nearly $1.7 billion in 2006-an astounding 66% a year. That can’t go on forever because Google can not possibly grow at that rate forever (it is an economic impossibility).
If we look at Google’s CROIC, we see that it is generating less cash per dollar invested today than it was in 2003-about 12% CROIC vs. 34% four years ago. Google is essentially generating less and less cash for each dollar it generated in the past-an indication that it may have an even harder time reinvesting cash in the future. And slowed growth is likely imminent at some point in the not-too-distant-future.
Predicting Google
If you try to predict the future of Google and use 66% as a future growth rate, you’ll see a business that is worth roughly $3,000 a share today. If you use CROIC, you’ll see a business worth roughly $225 a share. Which should you rely on? (Answer: I have no idea.)
And The Winner Is…
Though my growth rates may seem arbitrary, they are anything but. I prefer to project the future cash by using 75% of historical CROIC-slowed 10% in years 4-6 and another 10% in 7-10. No matter how much cash my company can generate in any given year, the true value of the company lies in how well it can reinvest that cash for growth.
After all, if a company has to fight for every penny of growth, it will eventually lose. As Peter Lynch said:
Go for a business that any idiot can run-because sooner or later, any idiot is probably going to run it.
Management can generate cash in any given year (FCF); still, a great business generates excess cash on its own at high rates (CROIC). Invest in the business, not just the management. After all, it is our capital that is invested and our return is tied to how well the company can use that capital to generate even more capital.
And On A Personal Note…
I will not be around the rest of the week. My wife is due tomorrow morning (if not today!) I likely will not be responding to comments or e-mails until the weekend at the earliest. Still, ask away because there are plenty of visitors here who “get it” and are more than happy to help. (Thanks all for helping build a great community here on F Wall Street!)
And like every other time I’m away from the computer: No, I will not be watching my stocks!
Filed under: How to Value a Business
Related Stocks: GOOG
Hi Michael,
The methodology is the same. The difference here is that, when FCF growth and CROIC are greatly different, you are better off using CROIC instead of FCF growth for future assumptions. In the case of JNJ, FCF growth and CROIC were close enough that you could use either one.
Hope that helps.
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Joe,
Read your piece on WMT today. I think that you are over thinking. The stock has gotten so cheap you don’t need much growth to make it a worthwhile investment.
Why do you use discount rate of 9%. WMT corporate bonds trade much lower than that and they have zero growth potential and are fully exposed to inflation. Truth is quite simply WMT is a good deal now at 7.5% earnings yield on purchase price vs. 6.25% or less on the bonds?
Keeping it simple.
-Fred
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In the post on valuing KO in 1997, you used FCF growth rate which was 20%+ while CROIC was 7%+, and concluded that you understood why Warren Buffett bought it (it so happened that history proved him right) in 1997. Why did you not use CROIC then to value KO in 1997?
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Fred, I believe the answer may be that bond yields (as quoted) do not factor in the tax implications of buying the bond, where you pay the taxes, versus investing in a firm that pays the taxes on net income, reinvests those profits to the stockholder’s benefit, and, if management is efficient and competent, generates compounded growth for you, the investor. Thereafter, you would need to take into account the equity yield — as you have begun –, after comparing it to the risk free cost of capital (the yield on the 10-year bond), a multiplier that compensates you for the volatility of the equities market (8.6 percent average since the crash of ‘29), and the volatility of the stock (its long-term beta).
In short, you are selling your savings too cheaply if demanding just 1.25 percent return over the corporate bond.
Graham’s original argument was that stable companies (i.e., those with stable earnings growth) could be more accurately valued because their intrinsic value could be determined in the same fashion as a bond (i.e., discounted cash flow models). Despite this, Graham recognized that firm performance was not assured over any period of time, and he required a margin of safety discount. Joe goes a step further with CROIC, in that this is what allows a firm to weather economic and sector down-turns. The intent is to follow Pabrai’s Dhandho analogy of severely limiting down-side risk while maximizing upside potential, as the market belatedly recognizes intrinsic value — “Heads I win. Tails I don’t lose too much.”
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I think Joe is saying that, when unsure of how to predict cash flow, use CROIC instead of free cash flow. It’s not the best way to invest (you should probably skip it if you aren’t sure), but CROIC is the long-term growth rate of the company.
It is all a guessing game. Even if CROIC was 3% and FCF was 10%, but you had a reason to believe that the future cash would grow at 20%, use 20%. The past is a guide, and CROIC is a better guide than FCF over long periods.
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I have seen your arguments, but growth rates are most of the time judgmental and arbitrary.That’s precisely where the concept of Margin of safety comes. I think it would be best to run different scenarios and see how the value look like.
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ok, trying to understand everything in this post took me an hour or so of oh so fun DCF calculations and what not =)
anyways, I’m having trouble understanding why using the croic figure is better at forecasting the future value. I mean, using the evaluation method that we all use, we add up all the cash the company ever created (SE) and all the cash the company will ever create, discounted back to today.
isn’t FCF growth fits the most for our evaluation? at the end of the day, what matter for the figure we get isn’t how much cash the company got for every dollar invested, it’s how much the company generated in total.
I can understand why FCF can be affected much more than CROIC by management actions (I guess you’re referring to the great affect it has on changes in working capital and capex – both part of the FCF calculation and due directly from management decisions) but still I don’t see a reason to use it as a growth rate.
Also, why 75% of croic? how did you get to this number?
Someone please help me fully understand this.
and Joe, thank you again for every single page in this website =)
Ziv.
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I would just like to add something, Croic would be a company’s growth rate only if they are investing 100% of their owner’s earnings/free cash flow back into their business. If they are paying dividends, buying back shares, paying off debt, or any other action that doesn’t invest capital back into the core business, then growth rate will most certainly be different than CROIC. If a company is making 15% on invested capital, they can only grow at 15% in the future if they reinvest their new capital (profits). If they only invest half their profits, and pay the other half out as dividends, then they will likely grow at a much slower rate than CROIC.
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Hello people,fantastic,no nonsense site for learning by the way.
With all thats been said above,if doing a DCF on a company,which of the two methods are best used for shorter time periods? (eg,for a 5 year or less investment,should you use the CROIC or FCF (oe) growth rate when doing a DCF?)
Also what about undervalued companies (on a DCF basis),that have low PEG’s,& some good growth ahead?
Thanks for any help.
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Joe – Thanks for the insight. I plan to play with it a little and see how it fits. Is there a reason that this approach differs from the methodology laid out in the JNJ discussion from last summer?
Congratulations on the newcomer and good luck with the accompanying life changing.
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