Analyzing Long Term Compound Annual Growth
Analyzing compound annual growth goes beyond looking at bottom-line earnings. We want to be especially sure free cash flow (FCF) is growing on a per-share bases. In addition, quality companies should be showing consistent growth from the top line to the bottom line. This includes growth in revenue, gross profit, operating profit, and net income levels. Consider the following flow diagram:
Each "step" of the way keeps a running total while something is added or subtracted out. For instance, to get to operating profit, certain expenses must be subtracted. This includes selling, general, and administrative expenses. And non-cash items including depreciation and amortization.
Why the Entire Flow Matters
Looking at each of these steps within the flow, we are first looking for steady and consistent growth. For instance, let's say a company has consistent net income growth but not FCF growth. This situation could be a red flag. The company could be making sales on credit but customers are failing to pay. The next step could be to check if accounts receivable (AR) is growing faster than revenue. This can happen when a company is trying to generate more income and sales by loosening credit. Eventually, the company will run into cash flow problems and will have to write off bad debts previously reported as income. This is one example but there are a number of other potential issues.
Actual Money vs. Per Share Numbers
FCF per share and earnings per share (EPS) are also important because of shareholder dilution. Employees may receive shares as part of their compensation. This becomes a problem when increasing shares causes the portion of the company you own to shrink.
CAGR Matrix
We provide a simple and straightforward way to quickly evaluate revenues, incomes and cash flows. In addition to providing metrics for each major "step" in the overall financial flow, there are some filters available. You can set a minimum value for all metrics. For example, you can require that revenue, gross profit, operating profit, etc. must be 10% or greater. Alternatively, you can set a minimum for single items like revenue growth.
For this example, I'm going to require that all compound annual growth (CAGR) metrics must be at least 10% per year. I'm also going to go with the default 10-year history and require that FCF Yield (a valuation metric) be displayed.
Next, the results displayed show companies that have generally have been great compounders historically. Clicking the "FCF Yield" header will sort the results by FCF yield in descending order. This will put the cheapest valuations at the top.
Alibaba stands out at the top for having an FCF yield over 10% while putting up great numbers across the board. While Alibaba has suffered revenue growth over the past year, revenue is expected to recover with a PEG ratio of only 0.79. If that holds true, the stock is very cheap. Of course, political risk is a major factor when considering Chinese companies.
PayPal appears to be another bargain. Although not growing as fast as many of the others, it is currently a good value for the price. PayPal, which took off during the pandemic, has sold off considerably. Similar to Alibaba, PayPal has also had slower growth in the past year.
Companies with lower valuations (having a high FCF yield) is frequently found with having slower revenue growth in the past year compared to their 5 or 10-year histories. If the company is fundamentally sound in that it returns to normal growth rates, then it's most likely undervalued. The trick is to determine whether something's fundamentally changed. For example, in PayPal's case, is the slower revenue growth due to consumers temporarily buying less (a temporary, cyclical issue)? Or is there too much competition that will prevent it from growing by double-digit figures in the future?
Strengths of the Long Term CAGR Tool
This tool is great for analyzing long-term financial performance of companies. It can screen for results that meet minimum growth benchmarks. It can also reveal cases where the top (revenue) and bottom lines (net income) get too much attention while big problems may be mounting. As mentioned earlier, if the growth rate of one part of the financials is completely out of proportion with other parts, it can be a symptom of a bigger problem. A deeper dive would be needed to determine if there was a one-time event (i.e. a legal issue) or financial statements that are manipulated.
Once companies that have a great compounding history are revealed through using the Long Term CAGR Tool, the next step would be to determine which companies will continue to deliver quality in their product/service and if the environment will allow the compounding trends to continue. In order for a quality company to keep performing, it must be able to maintain it's moat. That is, the ability to maintain competitive advantages over its rivals in order to protect its long-term profits and market share.
These advantages can include:
- Brand Strength: A strong, well-known brand that attracts loyal customers.
- Proprietary Technology: Exclusive rights or advanced technology that others cannot easily replicate.
- Regulatory Advantage: Favorable government regulations or licenses that limit competition.
- Cost Advantages: The ability to produce goods or services at a lower cost than competitors.
- Network Effects: The increased value of a product or service as more people use it, making it difficult for new entrants to compete.
- High Switching Costs: Situations where it is costly or inconvenient for customers to switch to a competitor.
Weaknesses of the Long Term CAGR Tool
For newer companies having very little financial history available, this tool won't have much use (which is why models like Rule of 40 and Rule of X were created). At least 5 years of financial history is required. In addition, many great companies are not profitable in the earliest years of their growth phase. This tool is best used to analyze quality companies with an adequate amount of financial history.
Even if a company has little financial history, the same competitive advantage rules listed above still apply. Companies that have great revenue growth may achieve a competitive advantage once they reach scale. For example, spreading more sales across the same fixed costs will eventually lead to a cost advantage.
Another thing to consider is everything that's happened to a company within the past year or so. As shown by the examples above, a company having both a strong long-term growth record and a low valuation could be either a great bargain or a sign of problems ahead. If there's been a recent sales/growth slump, you have to ask whether the slump is due to a temporary issue and if the company can return to growth that looks more like the long-term trend.