Previously we looked at the ways that growth, as well as Return on Invested Capital (ROIC), drive PE ratios. Our conclusion was that both attributes increase value, but noted that many investors ignore the value-enhancing benefits of high return on capital, concentrating instead only on growth. In this post, we will demonstrate that high returns on invested capital are far more sustainable than high growth rates and thus this metric is more important than growth in determining valuation.
Investors in a company care about the future cash generation of the business. Cash is generated both by sustaining and expanding the business as well as by optimizing the amount of cash that must be invested in the business to achieve growth. But it isn’t just next year’s results that matter or the year after that. Businesses are long-lived organizations and their value is determined by the long-term sustainability of their cash flow. So while ROIC and growth both drive valuation, it is the sustainability of these metrics that matter, not their outcomes in the next couple of years.
Below are a pair of charts from the book Valuation by McKinsey & Company. These charts examine the long-term behavior of growth and ROIC across publicly traded American companies. They divide the companies into quintiles and look at how companies growing (or generating ROIC) at a certain rate evolve over time.
Source: Valuation by McKinsey & Company
The growth rate chart shows that no matter how high (or low) a company’s growth rate, over time growth has historically converged to about 5% on average. This makes sense as the economy has historically grown at about 5% and if any group of companies grew faster than the economy over the long-term, they would quickly become larger than the economy itself (an impossible outcome). What’s surprising about this chart to many people is how rapidly fast growing companies see their growth slow. For a company growing at 17% initially (a rate of growth that would clearly label the company a “growth stock”), has seen their growth rate slow to 6%-7% on average within 5-years and then gone on to slow to 5%. While analysts will often project a company like this to grow at a double-digit rate for five years or more, in practice this sort of company will see its growth rate drop into the single digits within just two to three years. Even hyper growth companies growing at over 30% per year generally see their growth rate drop into the single digits within four years.
This rapid rate at which growth “decays” to average is a primary reason why investors should be hesitant to pay high valuations for quickly growing companies. While certainly some quickly growing companies maintain high growth for a decade or more, the average high growth company does not. Offsetting those potential long-term growth opportunities is the math behind average results that means that an equal number of current growth companies will see their growth rate collapse even faster than the averages shown above.
Source: Valuation by McKinsey & Company
This chart shows a similar study by McKinsey of how returns on invested capital evolve over time. While returns do show some level of decay, even over the very long-term high return businesses are able to sustain their rates of return. While American businesses have produced ROIC of 10% on average over time, companies that have initial high rates of return have not seen those returns decay towards average as we saw happens with growth rates. The average company with an initial ROIC of 17% was still producing an above average ROIC of 13% after five years and 12.5% over a decade later. Top performing firms returning 25% or more returns on capital have seen their ROIC persist in the mid-teens or better even over the very long run.
In our post on What Drives PE Ratios, we showed why a company with a high ROIC commands a high valuation ratio and we demonstrated the math behind the size of the valuation premium. This same math shows that a company with a 12.5% long-term sustainable ROIC will command a 20% valuation premium over the average stock. This is equivalent to a PE ratio of 19.2x vs the market average of 16x.
Keep in mind that this valuation premium is based solely on the enhanced ROIC and does not take into account any differences in growth rate. But as we saw, on average, both high growth and low growth companies see their growth rate converge towards the rate of economic growth in a relatively show period of time. What this means is that the valuation premium that growth companies command is real but fleeting. While the valuation premium that high ROIC companies command is meaningful and persistent.
The charts above forms the intellectual underpinnings of our investment philosophy, which focuses on finding competitively advantaged companies. Rather than look for statistically cheap stocks as many value investors do, we prioritize looking for moaty, high return businesses which we believe can sustain their rate of return on capital over the long-term. These companies are far more valuable than the average company and therefore represent a good value even when they trade at valuations that are not statistically cheap when compared to average companies.
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