The importance of growth is unquestionable when you are analyzing a business and its ability to generate surplus. No growth – no surplus. However, analyzing growth rates only can lead to a serious mistake.
Check Apple (AAPL) for example. Let’s calculate EPS growth rates for the latest 10 years. I’m going to use basic growth rate formula in order to do that:
To calculate how much EPS grew for the latest 5 years I will use recent EPS, which is 9.08 (as of September 2009) and EPS 5 years ago (as of September 2004), which is 0.34 and put those values into formula:
EPS Growth Rate = (9.08 / 0.34) ^ 1/5 – 1 = 92.895%
If you do the same for each year you will find consistent double-digit growth (please, refer to stock2own.com for details).
Awesome! This is a great business to buy, isn’t it? But in fact when you look at the historical data, you will see that the EPS went negative in 2001. Not so awesome… I’m not saying that you should not buy it, I’m just trying to point to a potential red flag here…
For any given stock, for any parameter, the growth rate will be great if current or most recent value is positive and large enough. If the company did not make a penny in all previous years, but managed to make some profits in the current year – all historical growth rates will look awesome. Mathematically speaking, this is correct.
This trap is waiting for you if you are not going to check raw data. Just taking a quick look to the growth rates is not enough. Positive growth is important, but if you want to calculate intrinsic value of a business, you have to make sure that this business is predictable or at least was predictable lately. By saying “predictable” I mean that business CONSISTENTLY grow.
The best way to check consistency is take a look to the raw data dynamics and year-over-year growth. I love to see those bars on the raw data diagram growing, especially for the latest 3-5 years. And, of course, I also want to do some kind of short term analysis and draw similar charts for quarterly data.
AAPL Raw Financial Data (fragment)
I think growth is as important as consistency. Talking about growth rates we are supposed to analyze growth rates. And if the business could manage to grow from negative value to positive, the growth is obvious. But we should worry about historical data dynamics as well as we worry about growth.
Tags: growth rate, predictability
