Choosing A Growth Rate: CROIC vs. FCF

October 16, 2007 by Joe Ponzio

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:

  1. Eventually (and sooner rather than later), that company would be larger than the global economy-an impossibility to say the least; and,
  2. 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!

A Note From Joe Ponzio

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