A question for Phil Town
from Mark in Falls Church, VA:
I just had a quick question about upper boundries. In Phil Town's book you often repeat the necessity of moat numbers remaining at or above 10% but do you believe there to be any moat numbers that are too high? I've heard that in general 25% earnings growth is about the highest one should allow before things get scary.
Can there be too much growth?
Oh yes oh yes there can be too much growth. The laws of compounding prove it.
If a business is growing at 50% a year, say, in ten years its earnings per share will be almost 60 times bigger than now. Presumably its revenue and equity and cash growth will keep pace (since it's a wonderful business, right?), so everything is 60 times bigger.
Let's take Google for an example. It's on track this year to have sales of $10 billion. It's growing revenue at 70% a year. If it continued to do that, how big would the sales have to be in ten years? $600 billion. Hmmmm.
Exxon, the biggest business in the world, has sales of $390 billion today, and in ten years could be over $1 Trillion in sales. So maybe Google could get there. But doesn't that seem a bit large for a business that isn't selling oil?
Yahoo got into this sort of logical inconsistency back in 1999. At that point, given the expected growth rate that it had to have to be worth what your fund manager was paying for it, by 2010, Yahoo would have had to have revenues that exceed the gross national product of the entire United States... or something crazy like that.
Point is, expecting huge growth rates to continue indefinitely is a form of "irrational exuberance" which is best avoided. Remember that the value of understanding the Meaning of the business as well as its Moat is to be able to make a reasonably accurate projection of the future. If you can't, then you really can't price the business, and if you can't do that, then you don't know what to pay, do you?
You are right, Mark. 25% is a heck of a high rate of growth to sustain indefinitely. Few businesses do it. If you find yourself convinced that the historical rate of growth is higher than that and if the average analyst agrees with you (remember that we use the lower of the analyst estimate or historical or our own) then I would be a bit worried that I didn't really know the business and industry well enough.
It isn't a bad idea to drop the growth rate to 25% on businesses like Google and see how they price out. In Google's case, a 25% growth rate and a 50 PE will still put the Sticker at $900 and the MOS right at $450.
Of course, Google is a bad example because it is definitely a Risky Biz stock with too little history to determine its growth rate and too technical a future to be certain where it will end up. But it's in my portfolio with these numbers.
Now go play. Phil Town
