You extrapolate the present growth rate of the start-up to the next 5-10 years and determine the future earnings of it. The extent of the accuracy of the future earnings of your start-up depends on how realistically you have incorporated the financials variable in determining the growth rate. The value investors search for the company that has good fundamentals and has good growth rate.
I am going to discuss the calculation of the realistic growth rate of the company
Growth rate helps us in decision-making
A higher growth rate company is generally more preferred than the lower one. Letâ€™s consider two companies, ABC Ltd and XYZ Ltd, both are having a net profit of Rs. 2.8 million in the present fiscal year. However, the company ABC Ltd is expected to grow at the rate of 15% while the company XYZ Ltd is expected to grow at the rate of say 5%
Their next year expected earnings will be as follows:
Well, there are different ways to calculate the growth rate, I will discuss the important ones and then derive the realistic growth rate out of them.
Extrapolate historical Earnings of your start-up
This is one of the simple methods to estimate the growth rate of the company. It takes into account the compound annual growth rate of last few financial yearsâ€™ earnings of the company. Let us understand this with the help of an example; the five-year net income (after taxes, interest, and depreciation) of ABC Ltd is as follows:
rate forever because as the company grows larger and bigger, it becomes difficult to sustain and maintain such high rate of growth. Therefore, it is not advisable to explicitly extrapolate present growth rates of the net-income into future growth rates.
The ROE (Return on Equity) can be used to predict the growth rate
Some people take a return on equity, (ROE = Net Profit/ Shareholderâ€™s Equity or Net worth), as the future growth rate of the company. But this growth rate is based on the assumption that all of the earnings will be reinvested into the growth and expansion of the company. But there might be a case when the company distributes part of its earning in the form of dividends, spend some amount of the net profit in servicing machinery etc and then re-invest the remaining amount for the growth. Therefore, the growth rates based only on ROE can also give you inflated growth figures as it has not discounted the dividends paid to the equity shareholders. The financial information of ABC Ltd is as follows:
â€‹The average of 5 years ROE is 27%, and if I assume this as the growth rate then the company is expected to grow at the rate of 27% per year. Again this growth rate in inflated one because it has not taken into consideration the dividends paid to the shareholders out of the Net profit.
The sustainable growth rate is the solution
It is that maximum growth rate which a company can achieve without borrowing debt from outside or without issuing new equity. It can be written as:
The relevant financial information of last 5 years of ABC Ltd is summarized in the table below:
â€‹It is giving me the average value of 24%; it means that the company can grow its sales and the profit maximum by 24% without taking any external loan or issuing any equity. But it also has some flaw; it does not take into account the debt part of the company. Suppose the company decides to accelerate its growth by borrowing money, in that case, the shareholder's equity will remain the same but the earnings will grow due to the effect of loan amount invested into the business that will subsequently increase the ROE of the company and ultimately the sustainable growth rate will also increase. In that case, the figure of sustainable growth rate is inflated as it does not include the debt part of the company.
Calculating the realistic growth rate
If I include the long-term debt part of the company before calculating the growth rate of the growth rate, it means that I am going to calculate return on capital not return on equity. This will be a more suitable measure of growth rate. Letâ€™s write it in an equation form:
(Net income - Dividends)/ (Share holder's equity + Long-term debt of the company)
The present long-term debt of ABC Ltd is Rs. 2 million
You can further deduct 25% of the above equation as an expense to service and repair the machines plus to keep the cushion for safety.
= 0.75 * [(2.8 - 0.28)/ (10.4 + 2)] * 100
= 0.75 * [2.52/12.4]* 100
= 0.75 * 0.203 * 100
â€‹It means that the company is expected to growth at the rate of 15.24%, if not forever but one can assume at least for next 10 years making it almost 5 times of its present size in the end of the 10th year from now.
â€‹I have tried to calculate the realistic growth rate in my own way but again this is not perfect, therefore you should cross check the things like the consistency in the earnings of your start-up. If the earnings of the company are stable and increasing then I think you are going on the right track with this calculation. But if there are wide fluctuations in the earnings year on year, it becomes difficult to predict the future earnings and for that, you must take further margin of safety to predict the growth rate. Yes, there is no well-defined way to calculate and predict the growth rate of the company but more variables you take, the closer you go to the realistic growth rate of your start-up. One more thing, if you have just started your business then this extrapolation might not be the right choice for you. Knowing the realistic growth rate of your start-up can obviously give your business a competitive edge, so try finding the growth rates using the above calculation and let me know your queries, all the best.