Is there a best way to estimate growth?

Fundamentals 22.  Growth is one of the key inputs when valuing companies. This post uses Leggett & Platt to illustrate the various issues when estimating growth.

 

One of the challenges in valuation is how to bring growth into the picture. This will vary depending on your financial model. 

• If you have a detailed financial model, you could have different growth rates for revenue and earnings.

• But if you are using a simple single-stage valuation model, what do you use to represent growth?  Do you use the growth in revenue or the growth in earnings? They are not necessarily the same. 

• And if you are using a multi-stage valuation model, there is the question of the terminal value. What should you use for the terminal growth rate?

The above is just one aspect of the issue. The more important one is how do you ensure that the growth rates you used are realistic?  Then there is the issue of organic growth vs growth via acquisitions. Do you need to distinguish them?

In the context of fundamental analysis, growth is more than just looking at changes in a parameter. Digging into the drivers of growth can also provide insights that can help you formulate your investment thesis.

Join me as I use Leggett & Platt (LEG or the Group) to illustrate the various growth issues.

Should go and buy it? Well, read my Disclaimer. 

Contents

• LEG background

• Growth profile

• Multi-growths model

• Single-stage growth model

• Insights from Reinvestments

• Conclusion

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LEG background

LEG is a US industrial Group with 3 business segments:

• Bedding Products.

• Specialized Products.

• Furniture, Flooring, and Textile Products.

I first covered LEG in my blog in Jun 2021. If you are not familiar with the Group, I suggest that you read the articles first. Refer to:

• Is Leggett & Platt a growth trap? (Part 1 of 2).

• Is Leggett & Platt a growth trap? (Part 2 of 2)

I also have 2 articles on LEG for Seeking Alpha. Refer to:

• Leggett & Platt: The Specialty Foam Potential.

• Leggett & Platt: Limited Financial Benefits From ECS Acquisition.

One of the key characteristics of LEG was the way it grew. LEG's business model appears to be one where there is annual closure or sale of business units as well as new acquisitions. The revenue growth is the net effect of these acquisitions and business closures. From 2010 to 2021:

• 14 business units were discontinued or sold.

• There were 32 acquisitions, including Elite Comfort Systems (ECS). 

• At USD 1.2 billion ECS was the biggest acquisition over the past decade. Excluding ECS, LEG only spent USD 0.67 billion over the past 11 years for the other 31 acquisitions.

Given this characteristic, I would consider the acquisitions and disposals as part of the “normal” CAPEX. On such as basis, LEG incurred an average net CAPEX of USD 111 million per year from 2015 to 2021. I also included the ECS acquisition in this. The net CAPEX is after accounting for the disposal of PPE and/or businesses. 

Note that this all-in approach does not apply to all companies. If the acquisition is a one-off affair, I would separate the organic growth with those from acquisitions.

Growth Profile

From 2015 to 2022, LEG had a 4.3 % CAGR in revenue as can be seen in Chart 1.

Chart 1: Segment Revenue

Source: 

a) Based on the segment financials worksheet as provided by LEG.

b) The 2022 revenue was estimated based on doubling the 1H 2022 revenue.

LEG growth was via a combination of organic growth and non-organic growth (via acquisitions). LEG provided a breakdown of the organic growth that I used to derive Table 1. You can see that growth via acquisitions is quite significant.

Table 1: Organic and Inorganic Growth 

Note:

a)  F F & T Products = Furniture, Flooring, and Textile Products

Table 2 compares the revenue growths with those for EBIT. You can see that while total revenue grew at a 4.2 % CAGR, it was only a 3.6 % CAGR for the total EBIT.

Table 1: Revenue and EBIT Growths

To further confuse the matter, from 2015 to 2021, total assets grew at a CAGR of 10.1 %. The point is that there are many growth components. As such what do you use to represent growth? To a certain extent, this depends on your valuation model.

Multi-growths model

Given that there were many different growth rates, the best way to model LEG is to develop a financial model with the various growth parameters.

The endpoint is to determine the Free Cash Flow to the Firm (FCFF) for various periods. The value of the firm is then the total discounted values of each period FCFF including the terminal value. 

One format is shown in Table 3 where there are main two growth phases:

• A high growth one from year 1 to year 10.

• A terminal phase based on a single-stage growth model. The FCFF for the terminal value is based on the final year value of the high growth phase.

In the model, the various parameters were modelled as:

FCFF = EBIT X (1-tax rate) - Reinvestment. 

EBIT = Gross profit - SGA.

= (Revenue X GP margin) - (Revenue X SGA margin).

I derived the Reinvestment based on the fundamental equation of Growth = Reinvestment rate X Return.

The discount rate was based on the WACC derived based on Damodaran’s build-up method for the Beta.

Value of Firm = Discounted value of the various FCFF + Terminal Value.

The Value of Equity = Value of Firm – Minority Interest - Debt + Cash.

Table 3: Example of a Multi-growths Financial Model

You can see from Table 3 that you could have different growth rates for the various parameters. In the example in Table 3, I assumed the following:

• 4.1 % annual growth for revenue.

• The gross profit margin improved by 1% every year.

• The SGA margin improved by 2% every year.

• A stable Reinvestment rate of 42.8 %.

• The terminal growth rate of 2 % in perpetuity.

• The same discount rate for all the years.

While theoretically correct, the above requires you to make assumptions about the various growth rates.

Given the challenges in projecting these growths or changes, I tend to avoid such a detailed financial model. Rather I generally use a single-stage growth model. 

Single-stage growth model

The single-stage Free Cash Flow to the Firm (FCFF) model could be based on the following:

Value = FCFF X (1 + growth rate) / (WACC – growth rate).

Where FCFF = EBIT X (1 – tax rate) X (1 – Reinvestment rate).

You can see that I would require a single growth rate for the equation. Do I use revenue growth or earnings growth or something else?

I recommend using the fundamental growth equation if you have such a situation. This is given by:

Growth = Return X Reinvestment rate

I defined Reinvestments = CAPEX + Net Acquisitions – Depreciation & Amortization + Changes in Working Capital

Reinvestment rate = Reinvestment / EBIT(1 – t). This is because I have defined Return = EBIT(1 – t) / TCE where

TCE = Total Capital Employed = Equity + Minority Interests + Debt – Cash.

Case Notes According to Professor Damodaran: “With both historical and analyst estimates, growth is an exogenous variable that affects value but is divorced from the operating details of the firm. The soundest way of incorporating growth into value is to make it endogenous, i.e., to make it a function of how much a firm reinvests for future growth and the quality of its reinvestment.” Consider the fundamental growth equation: Growth = Reinvestment rate X Return. The Reinvestment rate measures how much a firm is ploughing back to generate future growth. The Return is often based upon the firm's return on existing investments.  There are three separate scenarios of growth. The first is when there is a stable Reinvestment rate and Return over time. This is the case of using the equation as it is. The second is when the Return is expected to change over time. In this case, the expected growth rate for the firm will have a second component. This will increase the growth rate if the Return increases and decrease the growth rate if the Return on capital decreases. For details refer to Damodaran’s article. The third is the general scenario where revenue, operating margins, and other parameters changes over time. You should not use the fundamental growth equation here. The better approach is to build a detailed financial model where the various parameters such as revenue and profit margins are specifically modelled.  As you can see, you must understand what you are doing. If you are a newbie, seeing how others have handled growth can be a useful source of learning. Sites like Seeking Alpha.* are good sources. Click the link for some free stock valuation examples. If you subscribe to their services, you can tap into their business analysis and valuation.

Case Notes

According to Professor Damodaran:

“With both historical and analyst estimates, growth is an exogenous variable that affects value but is divorced from the operating details of the firm. The soundest way of incorporating growth into value is to make it endogenous, i.e., to make it a function of how much a firm reinvests for future growth and the quality of its reinvestment.”

Consider the fundamental growth equation:

Growth = Reinvestment rate X Return.

The Reinvestment rate measures how much a firm is ploughing back to generate future growth. The Return is often based upon the firm's return on existing investments. 

There are three separate scenarios of growth.

• The first is when there is a stable Reinvestment rate and Return over time. This is the case of using the equation as it is.

• The second is when the Return is expected to change over time. In this case, the expected growth rate for the firm will have a second component. This will increase the growth rate if the Return increases and decrease the growth rate if the Return on capital decreases. For details refer to Damodaran’s article.

• The third is the general scenario where revenue, operating margins, and other parameters changes over time. You should not use the fundamental growth equation here. The better approach is to build a detailed financial model where the various parameters such as revenue and profit margins are specifically modelled. 

As you can see, you must understand what you are doing. If you are a newbie, seeing how others have handled growth can be a useful source of learning. Sites like Seeking Alpha.* are good sources. Click the link for some free stock valuation examples. If you subscribe to their services, you can tap into their business analysis and valuation.

Valuation of LEG

To value LEG, I assumed that it had somehow managed to bring down its Reinvestment rate to a level based on the fundamental growth equation. 

I looked at 2 scenarios:

• Earnings Power Value (EPV) where there is no growth and zero Reinvestment rate.

• Earnings Value with growth. The Reinvestment rate here was derived from the fundamental growth equation.

Based on the above, the value of LEG was estimated as follows:

• EPV = USD 24 per share.

• Earnings Value with 3 % growth = USD 25 per share.

• Market price as of 28 Sep 2022 = USD 34 per share.

The details of my computation and the assumptions used are shown in the following tables. The key points to note are:

• I use Total Assets and EBIT / Total Asset as the key metrics as per Table 4. The EBIT was derived based on the average 2019 to 2022 EBIT / Total Assets of 10%.

• The 3 % growth as per Table 5 was also based on the growth in the Total Assets.
  
  
• Given the change following the acquisition of ECS, I derived the values of many of the metrics based on the 2019 to 2022 performance. Refer to Table 6. I took the 2022 performance as doubling the first half-year 2022 results. 

• I estimated the WACC by taking the average of the values that I found. These were based on the first page results of a Google search for “Leggett and Platt WACC”. Refer to Table 7.

Table 4: Calculation of EPV

Table 5: Calculation of EV with Growth

Table 6: Valuation Assumptions

Note that in the model, I defined FCFF = EBIT X (1 – tax rate) X (1 – Reinvestment rate).

In other words, I consider the after-tax value for EBIT. For consistency, the Reinvestment rate should then be based on the after-tax rate.

Secondly, the growth was based on growth in Total Assets. As such, the Return should be based on Total Assets.

In other words, the Return should be = EBIT(1 – t) / Total Asset.

That is why in Table 6, I have the term EBIT(1-t)/Total Asset.

Table 7: Estimating WACC

Getting to realistic growth

There are 2 ways to help ensure that the growth used and the valuations are realistic. The first is to look at the track record.

The other is to look at the business prospects. In the case of LEG, this is diving into the prospects of each of the business segments. 

The 3 business sectors that LEG operates in are not exactly growth sectors.

• The US bedding (mattresses and foundations) market grew at a CAGR of 5.6 % from 1997 to 2017.  The forward growth projections are below the long-term US GDP growth rate of 4 %.  The non-US market is projected to grow at a slightly higher rate than that of the US. I have a comprehensive write-up on this sector in my Tempur-Sealy post that you can refer to. 

• According to Statista, revenue in the US furniture market amounted to USD 230 billion in 2022. The market is expected to grow annually by 4.5 % (CAGR 2022-2026). On a global basis, most of the revenue is generated in the United States.

• According to Grand View Research the global flooring market size was valued at USD 257 billion in 2021.  It is expected to grow at a compound annual growth rate (CAGR) of 5.6 % from 2022 to 2030.

• In the Specialized products segment, the Automotive group accounted for about ¾ of the segment revenue. Statista projected that global auto sales to grow from USD 2,755 billion in 2020 to USD 3,800 billion in 2030. This is equal to a CAGR of 3.3 %.

The point here is that you are projecting future performance. Looking at the track record is not enough. Complement them with industry and market trends.

Finally, when estimating the growth for the terminal value, you have to ensure that it is capped at the long-term GDP growth rate. Otherwise, you will have a situation where the company would eventually be larger than the economy.

Damodaran has even suggested that you cap the terminal growth at the risk-free rate. 

Insights from Reinvestments

Reinvestments can also provide insights when analyzing companies. 

From 2015 to 2021, LEG incurred an average of USD 523 million on Reinvestments. When compared with the PAT we have:

Reinvestment rate = Reinvestment / PAT

Table 8 tabulates the Reinvestment rates for LEG from 2015 to 2021. You can see that it is greater than 100% for most of the periods. This is not a sustainable rate as it meant that LEG was not able to generate sufficient PAT to fund the growth. It had to increase its Debt. This is supported by the high Debt Equity levels as shown in Chart 2:

Table 8: Reinvestment Rates

Chart 2: Debt Equity Trends

Source: Based on the quarterly financial worksheet as provided by LEG.

Can LEG achieve a sustainable Reinvestment rate?

To lower its Reinvestment rate, LEG needs to either:

• Improve its profits for the same quantum of Reinvestments. The Reinvestment rate can be a metric to measure this.

• Have more effective Reinvestments. One way to interpret this is to have lower Reinvestments for the same quantum of changes in revenue or Total Assets.

As can be seen from Table 8, there is no reducing trend. In other words, there was no improvement in profits for the same quantum of Reinvestment.

Chart 3 shows the past 12 years of Reinvestments as ratios of the changes in revenue and changes in Total Assets. There does not seem to be any trend. This suggests that LEG did not manage to improve the effectiveness of its Reinvestments.

These are back-of-envelop analyses, but it does show that it would be challenging to reduce the Reinvestment rates. 

Chart 3: Effectiveness of Reinvestments

Financial position

I have concerns about LEG’s financial position looking at the following. 

I have earlier shown that LEG has a high Debt Equity ratio. The more worrisome point is that LEG had not been able to generate sufficient Cash Flow from Operations to reduce this Debt.

• From 2012 to 2021 it generated an average of USD 477 million in Cash Flow from Operations per year. 

• During this period, it paid out an average of USD 195 million in annual dividends and spent USD 100 million annually on share buybacks. 

• The average CAPEX was RM 111 million.

• This leaves a balance of USD 71 million per year for reducing the current USD 2.3 billion Debt.

Something has to be reduced if Debt needs to be pared down. This does not paint a good future for dividends, share buyback, or CAPEX.

In my analysis, I had included the ECS acquisition. This is of course a very large one. If we ignore ECS, the average CAPEX reduces to USD 50 million. Even then the balance is still small relative to the Debt.

The point I am making is that the analysis can provide insights into the likely scenario. For example, in the case of LEG:

• If the focus is on Debt reduction, we are unlikely to see another big acquisition. It means that there is no acquisition news to excite the market. 

• I suspect that LEG would probably reduce the share buyback but protect the dividends as the way to further reduce the Debt.

Conclusion

Growth is one of the inputs in the valuation process. How you bring growth into the valuation process will depend on your valuation model.

I have illustrated 2 approaches:

• The first is a comprehensive one where the financial model enabled you to have different growth rates for each parameter. But this will require making assumptions about each metric. I try to avoid this approach as it can turn into a number-crunching exercise if you are not careful. 

• The second is a simple single-stage growth model. 

Valuation is about determining the discounted values of the Free Cash Flows generated by the business over its life. It is already very challenging to determine the Free Cash Flow to represent the “normalized” future performance. Now you have also to determine the growth rate. Furthermore, you have to tie growth to the fundamentals of the business.

Given the many challenges, I prefer to use the single-stage Free Cash Flow model. I then determined the growth rate from the fundamental growth equation of Growth = Reinvestment rate X Return.

In using the fundamental growth equation, you need to ensure that you are consistent. If growth is based on Total Assets, then the return should be based on Total Assets. If growth is based on the Total Capital Employed, the return should be based on the same metric.

Even when using the fundamental growth equation, you have to check that the growth is realistic. This is because growth is dependent on the Reinvestment rate and Return. You have to check that what you assumed for these are realistic. 

There are a few ways to carry out such a sanity check. Look at the historical performance. Look at industry performance. I also look at market research reports to get a sense of the revenue growth rate. And don’t forget to cap the terminal growth at the long-term GPD growth rate.

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