First off: this is by no means a philosophical diary, though that would be really interesting as I think much of the growth thinking/dogma in the (Anglo-Saxon thinking dominated) business world, eventually comes down to philosophy / religion (e.g. the Puritans...). But for that I clearly lack even the slightest intellectual background so I'll leave that to others! Furthermore, analyzing the ramifications of having growth as the cure for everything and the pressure not just on employees but society as a whole would be very interesting.
However, in the following, you will find a very simple and quick explanation why Wall Street analysts (or stock analysts in general) love, and stock-option stoked CEOs are always eager to preach, "growth stories". Of course, this is mainly boring finance basics stuff (which I'll try to keep simple and short). If you are already a finance type, then this is probably nothing new, however I think a review of the "power" of this simple formula might open an eye or two (or none), so just skip the basics and go straight to the Gordon Growth Model for a quick refresher.
The value of an asset
From a finance perspective, assets (e.g. a house, land, a wind farm, a company) are worth having because the owner of that asset is entitled to a cash-flow stream (e.g. rental income from a house, profit made from owning a wind turbine or the dividends from owning stock in a company) in the near and far future.
In summary, a financial investor is only interested in the pure money that can be derived from the investment today and in the future. Things like the beautiful view from the mountain-top house or the prestige of owning a company that does something "cool" is not put into the equation.
Time-value of money
The tricky thing about the above mentioned asset is, what is the "right" price of the asset? To calculate the correct present value (as the terminus is commonly known as) of the asset, the future cash flows are discounted using an adequate discounting factor. Without going into too much detail, discounting is like giving interest rate on a savings account, only backwards.
Simple example: if the interest rate is 3.00% p.a., then your savings account which has EUR 100.00 today, will have EUR 103.00 in one year, i.e. 100 x 1.03^1 (Cash today (times) interest rate (to the power of) the number of years). Conversely, a savings account which in two years is worth EUR 106.00, has a "correct" price today of?
106 / (1.03^2) = EUR 99,92
The reason for it being less than 100 is the compounding power of interest (i.e. interest on the interest), which also applies for discounting...
Present Value of Cash Flows
As stated above, the "right" price of an asset depends on the future cash flows that can be derived for it, discounted to today. If you have more than one cash-flow, the formula will be the following:
Price (P) = Sum of [(CF of each year) / (discounting factor to the power of the respective year)].
An 18-year old wind farm which generates profits of EUR 60, 60 and 50 for the next 3 years (at which point it will scrapped )in a "6% world" is therefore worth:
[60/(1.06^1)] + [60/(1.06^2)] + [ 60/(1.06^3)] = 151,98 (i.e. less than 60+60+50=170).
Present Value of a Perpetual Cash Flow
If you have a single cash flow which goes on forever there is a simple formula:
PV = CF / r
I'm not going to prove it, just trust me or do a search on perpetuity.
A boring "non-growth" company which pays dividends of EUR 25 p.A. and has a capital cost (I won't go into detail) of 9% (a typical rate for a utility company in Europe) would therefore be worth:
P = EUR 25/0.09 = EUR 277,77!
Present Value of Dividends of a growing company (the Gordon Growth Model)
The above formula obviously only works if the dividend is constant. What, however, happens, when the revenue, earnings and thus eventually the dividend grows? Well , there again, is a simple formula, the one mentioned at the beginning:
P = D / (r-g)
Essentially, it is the perpetuity formula with the only difference being that the discounting factor is reduced by the (perpetual!) growth. So, let's do an example.
Let's build a growth company!
Let's take that boring European utility (using mostly coal-fired power plants) from above and let's turn it into a sexy, renewable energy power house! What do we do? Well, the CEO announces that Big Bad Utility will now change its investment budget to include a big renewable energy portion, mainly wind, and a sizeable amount of that in offshore wind. As that is perceived to be more risky than its old business, the CFO of company revises the capital costs upward to reflect this (from 9% to 12,5%).
Therefore the price of the company will? Yes, actually it will go DOWN, as the discounting factor is now higher, i.e.
P = EUR 25/0,125 = 200!!!
But wait, it's not that easy! Since renewable energy is a growing market the CEO of the now-sexy utility tell his shareholders that they can calculate with an earnings growth of about 5-7% p.a. (let's say 6% average) So, let's take the Gordon Growth Model to calculate the correct price of the utility:
P = EUR 25 / (0.125-0.06) = EUR 384,62!!!
Wow! What a difference 6% growth makes, eh?
The most important implications of this are:
- growth is the easiest way to push up a stock price
- failure to meet growth is the easiest way to push DOWN s stock price
Coupled with the quarterly reporting mania leads to intense pressure on employees to fulfill their (far stretched) goals. And since a lot of managers are paid in stock (and also have a considerable part of their wealth in company stock), these managers might at best be distracted from profitable long term goals/projects to fulfill the short term goals and at worst be tempted to cook the books in some way or another...
It also explains why everyone always has a growth story (it's a lot easier to tell growth stories than to actually perform!) and when you add up the growth prognosis of all companies of a sector strangely the market is often a lot bigger than it should be...
And to think that in some countries a lot of the pensions are built up on this very weak CEO fairy tale world... Which reminds me that I need to finally write up a diary on why pay-as-you-go pension systems aren't that bad, and might actually be better than the Anglo-Saxon model which has been so diligently preached in Europe the last couple of years. In fact I remember my professor of banking who couldn't give a good answer to my question why stocks should be able to outperform GDP growth in the long run, just some, empirical analysis of the past years, blah blah blah...
Crazy times we live in.
