Assessing the viability of growth
How do you identify the future value of any growth in a business? Every investor faces the same challenge when considering the relative attraction of a range of stocks. There are a number of key components that provide the right environment for future growth: an attractive product, an efficient business model that minimises unprofitable spending; and good management. But, ultimately, future growth starts with sustainable, long-term cash generation.
A starting point in assessing the value of growth is to look at the historic return on invested capital. While any profit may be returned to investors in the form of dividends, it would be a mistake to assume that this ‘cash in hand’, whether generated by higher earnings or cost-cutting, has more value than money that is reinvested for growth.
Given the uncertain economic backdrop, it is more important than ever to be sure of the quality of a franchise or where you are in the capital cycle when you are looking at the value of growth. A business that invests too much in its growth, or reinvests poorly, may see its expenditure outstripping the value of any future gains – i.e. destroy shareholder value. Similarly, a company that is investing in growth may be too early in the cycle to be considered an attractive investment.
So how do you value a company’s ability to grow? In the words of investment legend Warren Buffett: “Businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return.”
We take a conservative view and check publically available information carefully to assess whether or not the business generates a positive return on its expenditure. To do this, we need to understand how the company intends to finance future growth, and whether or not this growth is sustainable, given the level of competition it may face. Ultimately, growth is driven by a company’s ability to sell its products profitably; and to reinvest free cash to generate higher earnings in the future. Any stock that can offer long-term contracts, sustainable earnings, a strong market position or a healthy pipeline, could well represent good value on a long-term basis. We also try to understand how much any growth might be worth, placing it in the context of any increasing competition.
‘Value of growth’ in action
RELX Group (Anglo-Dutch publisher)
RELX Group (previously Reed Elsevier) is a leading provider of professional publishing services across industries, with strong positions in areas such as scientific, legal, risk and exhibitions. We have held it in our wider strategy since 2011 and believe the market is currently underestimating further growth.
The company offers high margin, high return on equity characteristics and its recurring sales and subscription model provides resilience to the business, supporting a healthy and sustainable balance sheet. The management team is well embedded, with long-term incentive plans that require them to own significant stakes in the company. The firm’s revenue streams are well protected, with significant barriers to entry from strong client relationships, valuable back catalogue and the exclusivity of the product.
Despite the company’s track record of earnings uplifts, as illustrated in the chart below, we do not believe that the market has yet fully recognised the prospects for further revenue growth.
RELX: earnings power and growth
Source: Bloomberg, as at 9 March 2016.
LHS: earnings per share expressed as euros. RHS: net income in euro billions.