Growth is simply how much a company is growing. When a company grows, its free cash flow will grow with it, and this is great for us investors. So the more a company is growing, the more valuable that company will be in the future. Also, growth compounds year after year, and it leads to quite astounding numbers. Of all the things Einstein did in his life – nuclear bombs, harnessing electricity from the sun, inventing relativity – he called compounding the most incredible thing he’s ever learned of, saying ‘compounding is the eighth great wonder of the world. He who understands it, earns it. He who doesn’t, pays it’. That’s pretty solid credibility for the magic of compounding. For example, if you can grow by 33% each year for five years, you’ve grown by 4-fold in just 5 years. It’s exponential, and that leads to wildly high numbers.
Now, there’s two ways a company can grow its free cash flow:
- Increased Sales – by selling more things, the company will grow its sales and its free cash flow. This is the best indicator of growth.
- Increased Efficiency (Margins) – companies can cut costs to grow their free cash flow without growing sales. However, this will be only temporary growth, as eventually they’ll run out of things to cut. Further, cutting costs has significant repercussions. If you’re cutting costs on advertising then less people will know about your product. If you cut product development costs then you’ll end up with a poorer quality product that will lose you customers.
So we can see that improving efficiency in order to grow can harm the company, and its only a temporary measure, whilst increasing sales is a true form of growth. So when looking at a companies growth, base it off their growth in sales and nothing else.
Now which growth in sales to look at. There’s two options – the first is that you can use last year’s sales growth. However, this may be abnormally high or low. If it’s part of a gradually increasing trend in year-on-year growth, then just use that. The second way to find the growth is to use the compounded annual growth rate for the past 5 years (this is like calculating the average over the past 5 years). This will give a much more conservative long-term growth, and so it’s a more realistic and longer-term number.