To understand sustainable long-term earnings, it’s crucial for investors to be able to look beyond the short-term noise generated around a particular company. We need to consider a company’s potential long-term growth rate as well as the appropriate inputs to accurately model sustainable profitability. Investors are often blinded by the current environment, thinking it will continue indefinitely – which is why cyclical companies tend to be overvalued during the good times and undervalued when times are tougher.
A change of only one percentage point in a company’s expected growth rate after year three should move a company’s valuation by 16% – more than a full year’s expected returns in the South African market. This is why markets generally perform well when sentiment improves – investors are then more willing to ascribe higher ‘terminal values’ (the value of companies’ expected cash flows beyond the forecast horizon).
While investors can of course not gaze into a crystal ball and accurately predict events far into the future, we can at least make certain reasonable assumptions. In our view, determining the long-term growth rate has three facets:
- The results of investment into growth avenues
- Product price inflation
- Volume growth.
Given that management teams don’t last forever, and the high forecast risk associated with predicting their decisions well into the future, we assume that most companies will reach a ‘steady state’ within eight years. After this, the assumption is that companies will pay out all free cash as dividends.
Price inflation poses a fascinating question. Some businesses are inherently better than others at passing this on to customers. This is a function of many factors, of which the most important is technological risk – for example, peanut butter manufacturers face less risk of technology changes driving prices down than do telephony service providers. While the price of a mobile phone call is a third of what it was 20 years ago, a packet of chips costs more than three times as much. Over time, commodity prices decline in real terms as extraction technology improves and substitutes are developed.
Long-term volume growth for steady-state companies is limited by real gross domestic product (GDP). No business can grow ahead of GDP forever, or it would eventually encompass the entire economy. And we know from history that technological change drives most industries’ share of the economy down over time. The world’s five largest listed companies are all less than 40 years old, and three of them are not only under 25, but were unimaginable to most people 25 years ago.
When valuing a business, they key question to ask is therefore: how much slower is its steady-state volume growth likely to be than GDP growth? While a company like Tiger Brands should sustainably grow volumes at greater than 90% of GDP, a cigarette company would likely see volumes decline.
Putting our two calculable factors together, for a company like Tiger Brands, we get these steady-state figures: 100% inflation pass-through at 5.5% long-term inflation and a 90% multiplier of 2% long-term real GDP growth gives a long-term growth rate of 7.3%. By contrast, Sasol would require major capital to grow volumes and so we model zero steady-state volume growth and only 75% inflation pass-through, to give us a terminal growth rate of 4.1%. The difference is why Tiger Brands justifies a forward price-to-earnings multiple (P/E) of around 16 times, while Sasol only justifies around 10 times.
In conclusion, investors should avoid paying for growth too far into the future, but be prepared to pay higher P/E multiples for businesses with superior inflation pass-through.
