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Growth, Growth, Growth!!!

by crankykarsten Thu Apr 22nd, 2010 at 05:13:28 AM EST

Everywhere nowadays you can hear about how important growth is. Be it economic growth of countries / regions or businesses.  Growing up as a capitalist-minded teenager I never really questioned the need for growth. Growth is good, just like bigger is better, etc... However, starting with my university years (business and economics) and further studies in this field, it has become quite clear why growth is good, at least for companies listed on stock exchanges. The simple answer is P = D / (r-g).  It dawned on me only a couple of years after learning this formula (and working at several stock-listed companies in different functions including sales and procurement) why this simple formula is so powerful. More after the fold...

front-paged by afew


First off: this is by no means a philosophical diary, though that would be really interesting as I think much of the growth thinking/dogma in the (Anglo-Saxon thinking dominated) business world, eventually comes down to philosophy / religion (e.g. the Puritans...). But for that I clearly lack even the slightest intellectual background so I'll leave that to others! Furthermore, analyzing the ramifications of having growth as the cure for everything and the pressure not just on employees but society as a whole would be very interesting.

However, in the following, you will find a very simple and quick explanation why Wall Street analysts (or stock analysts in general) love, and stock-option stoked CEOs are always eager to preach,  "growth stories". Of course, this is mainly boring finance basics stuff (which I'll try to keep simple and short). If you are already a finance type, then this is probably nothing new, however I think a review of the "power" of this simple formula might open an eye or two (or none), so just skip the basics and go straight to the Gordon Growth Model for a quick refresher.

The value of an asset

From a finance perspective, assets (e.g. a house, land, a wind farm, a company) are worth having because the owner of that asset is entitled to a cash-flow stream (e.g. rental income from a house, profit made from owning a wind turbine or the dividends  from owning stock in a company) in the near and far future.

In summary, a financial investor is only interested in the pure money that can be derived from the investment today and in the future. Things like the beautiful view from the mountain-top house or the prestige of owning a company that does something "cool" is not put into the equation.

Time-value of money

The tricky thing about the above mentioned asset is, what is the "right" price of the asset? To calculate the correct present value (as the terminus is commonly known as) of the asset, the future cash flows are discounted using an adequate discounting factor. Without going into too much detail, discounting is like giving interest rate on a savings account, only backwards.

Simple example: if the interest rate is 3.00% p.a., then your savings account which has EUR 100.00 today, will have EUR 103.00 in one year, i.e. 100 x 1.03^1 (Cash today (times) interest rate (to the power of) the number of years). Conversely, a savings account which in two years is worth EUR 106.00, has a "correct" price today of?

106 / (1.03^2) = EUR 99,92

The reason  for it being less than 100 is the compounding power of interest (i.e. interest on the interest), which also applies for discounting...

Present Value of Cash Flows

As stated above, the "right" price of an asset depends on the future cash flows that can be derived for it, discounted to today. If you have more than one cash-flow, the formula will be the following:

Price (P) = Sum of [(CF of each year) / (discounting factor to the power of the respective year)].

An 18-year old wind farm which generates profits of EUR 60, 60 and 50 for the next 3 years (at which point it will scrapped )in a "6% world"  is therefore worth:

[60/(1.06^1)] + [60/(1.06^2)] + [ 60/(1.06^3)] = 151,98 (i.e. less than 60+60+50=170).

Present Value of a Perpetual Cash Flow

If you have a single cash flow which goes on forever there is a simple formula:

PV = CF / r

I'm not going to prove it, just trust me or do a search on perpetuity.

A boring  "non-growth" company which pays dividends of EUR 25 p.A. and has a capital cost (I won't go into detail) of 9% (a typical rate for a utility company in Europe) would therefore be worth:

P = EUR 25/0.09 = EUR 277,77!

Present Value of Dividends of a growing company (the Gordon Growth Model)

The above formula obviously only works if the dividend is constant. What, however, happens, when the revenue, earnings and thus eventually the dividend grows? Well , there again, is a simple formula, the one mentioned at the beginning:

P = D / (r-g)

Essentially, it is the perpetuity formula with the only difference being that the discounting factor is reduced by the (perpetual!) growth. So, let's do an example.

Let's build a growth company!

Let's take that boring European utility (using mostly coal-fired power plants) from above and let's turn it into a sexy, renewable energy power house! What do we do? Well, the CEO announces that Big Bad Utility will now change its investment budget to include a big renewable energy portion, mainly wind, and a sizeable amount of that in offshore wind. As that is perceived to be more risky than its old business, the CFO of company revises the capital costs upward to reflect this (from 9% to 12,5%).

Therefore the price of the company will? Yes, actually it will go DOWN, as the discounting factor is now higher, i.e.

P = EUR 25/0,125 = 200!!!

But wait, it's not that easy! Since renewable energy is a growing market the CEO of the now-sexy utility tell his shareholders that they can calculate with an earnings growth of about 5-7% p.a. (let's say 6% average) So, let's take the Gordon Growth Model to calculate the correct price of the utility:

P = EUR 25 / (0.125-0.06) = EUR 384,62!!!

Wow! What a difference 6% growth makes, eh?

The most important implications of this are:

  1. growth is the easiest way to push up a stock price

  2. failure to meet growth is the easiest way to push DOWN s stock price

Coupled with the quarterly reporting mania leads to intense pressure on employees to fulfill their (far stretched) goals. And since a lot of managers are paid in stock (and also have a considerable part of their wealth in company stock), these managers might at best be distracted from profitable long term goals/projects to fulfill the short term goals and at worst be tempted to cook the books in some way or another...

It also explains why everyone always has a growth story (it's a lot easier to tell growth stories than to actually perform!) and when you add up the growth prognosis of all companies of a sector strangely the market is often a lot bigger than it should be...

And to think that in some countries a lot of the pensions are built up on this very weak CEO fairy tale world... Which reminds me that I need to finally write up a diary on why pay-as-you-go pension systems aren't that bad, and might actually be better than the Anglo-Saxon model which has been so diligently preached in Europe the last couple of years. In fact I remember my professor of banking who couldn't give a good answer to my question why stocks should be able to outperform GDP growth in the long run, just some, empirical analysis of the past years, blah blah blah...

Crazy times we live in.

Display:
first that comes to mind ist MSNBC.
by crankykarsten (cranky (where?) gmx dot organisation) on Tue Apr 20th, 2010 at 04:28:10 AM EST
European Tribune - Growth, Growth, Growth!!!
why stocks should able to outperform GDP growth in the long run

Hmmm, nice one.

by afew (afew(a in a circle)eurotrib_dot_com) on Tue Apr 20th, 2010 at 05:12:03 AM EST
it's something that has been flying around in my head for quite a while which I finally want to put to writing with a diary on pensions. I don't know where that article will head, but I am thinking something like 2% management fee plus other costs for everyone to invest in the same universe instead of just taking GDP is a pretty bad transfer of wealth to the finance industry. Mind you, this always assumes (as is the case) that most funds invest in the secondary market and not the primary market...
by crankykarsten (cranky (where?) gmx dot organisation) on Tue Apr 20th, 2010 at 06:51:14 AM EST
[ Parent ]
sorry,  I meant taxing GDP
by crankykarsten (cranky (where?) gmx dot organisation) on Tue Apr 20th, 2010 at 06:52:21 AM EST
[ Parent ]
That would be an interesting diary. Strongly encouraged!
by afew (afew(a in a circle)eurotrib_dot_com) on Tue Apr 20th, 2010 at 07:28:42 AM EST
[ Parent ]
The problem is that growth is a positional good. The fact that your growth is bigger than the other guy's (sic) is at least as important as actual spending power.

So it's impossible to have too much growth, and it's also impossible to do sensible long-term planning when your growth is expected to 'perform' (sic) every day, all the time.

by ThatBritGuy (thatbritguy (at) googlemail.com) on Tue Apr 20th, 2010 at 07:34:48 AM EST
[ Parent ]
@tbg

important psycho-point. sanity posits growth as 'upwards and onwards' towards some definable goal, (utopia, gift economy, whatever your image of a better future is(, iow a move to the positive, with attendant sense of arrival, accomplishment, satisfaction, resolution etc, one where equilibrium is possible, whereas for the neurotic mind growth is seen as escape, a ladder out of hell, a way to keep the hounds of the baskervilles from catching up with you, and since these demons are rooted, rotting in the neurosis, there can never be an escape, as no matter how many positional goods one attains, there's always the fear that joe blow next door has the newer model. so there is no equilibrium, resolution, etc, just the 'hungry ghost'* mentality.

aaagh, talk about yer hamster wheel...

* buddhist term for a lost soul, who eats and eats and still stays thin as a wraith.

back to chopping wood and carrying water.

'The history of public debt is full of irony. It rarely follows our ideas of order and justice.' Thomas Piketty

by melo (melometa4(at)gmail.com) on Thu Apr 22nd, 2010 at 06:28:22 AM EST
[ Parent ]
The solution would seem to be to make sanity the norm rather than the exception. But how is the question.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Thu Apr 22nd, 2010 at 03:33:24 PM EST
[ Parent ]
The answer is change minds, not industries.

Humans need far less stuff when their head seems full.

Growth is the philosophy of the cancer cell.

This is a brainless diary.

Align culture with our nature. Ot else!

by ormondotvos (ormond.otvosnospamgmialcon) on Thu Apr 22nd, 2010 at 06:43:28 PM EST
[ Parent ]
Well, it is clear that you do not see the substance that I see. The diary does not advocate growth, growth, growth. It shows why the meme has had the power that it does. It is essential to understand that if it is to be confronted.

Please do not make denigrating characterizations of those who go to the effort to attempt to explain important aspects of our economy and society. I find the dairy valuable and worth re-reading. It amplifies insights I have obtained through other recent reading. But you may find this comment "brainless" as well. I am giving you the courtesy of this explanation rather than using one of the lower ratings for your comment.

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Thu Apr 22nd, 2010 at 10:33:24 PM EST
[ Parent ]
thanks for defending me! :-)

Some people manage to comment without even reading the first paragraph. But that's how the internet (unfortunately) often works...

by crankykarsten (cranky (where?) gmx dot organisation) on Fri Apr 23rd, 2010 at 11:43:39 AM EST
[ Parent ]
Well, it is awkward to defend one's self from such characterizations and it is part of what I am supposed to be doing, anyway. But you are more than welcome. I look forward to your next diary.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Apr 23rd, 2010 at 02:57:00 PM EST
[ Parent ]
Hint! When ten people, including Jerome and other editors have recommended a diary it is a bad idea to call it brainless.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Thu Apr 22nd, 2010 at 10:45:47 PM EST
[ Parent ]
ARGeezer:
But how is the question.

slowly, patiently, one person at a time, maybe?

'The history of public debt is full of irony. It rarely follows our ideas of order and justice.' Thomas Piketty

by melo (melometa4(at)gmail.com) on Fri Apr 23rd, 2010 at 12:01:03 AM EST
[ Parent ]
The key question is: Growth denominated in what?

Growth denominated in deficit-based currencies - where money is created as credit based on a claim over upon interest-bearing debt - is responsible, when combined with the 'For Profit' enrterprise model, for the shit we are in.

Growth denominated in energy, on the other hand, would be very different.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Tue Apr 20th, 2010 at 07:39:46 AM EST
since I'm on parental leave for the next 5 months maybe I'll finally have time to read (and understand) your ideas better, then I could answer your question intelligently :-)

For now I would define growth as the amount of work done combined with the efficiency of how that work is done. Whether you denominate that in gold, fiat money or energy isn't relevant for the point that I will try to make.

by crankykarsten (cranky (where?) gmx dot organisation) on Tue Apr 20th, 2010 at 08:40:28 AM EST
[ Parent ]
For now I would define growth as the amount of work done combined with the efficiency of how that work is done.

Nitzan and Bichler devote most of a chapter and parts of others to an analysis and discussion of Marxist and Neo-Classical, (mostly unsatisfactory), approaches to this subject in Capital as Power. The book is only 400 pages, but would still soak up some of your spare time, while baby is napping. :-)

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Tue Apr 20th, 2010 at 11:27:56 AM EST
[ Parent ]
also believe in growth. Check your average 5-year plan for details. And, many people somewhere in between also believe in growth...if for no other reason that there are, every year, more and more people to feed, clothe and house via that growth, and the health and vitality of a society is and has always been inextricably tied to the vitality of its demography and its socio-economic progress, and this for many reasons not limited to defence of the homeland, cultural achievement, and social and material well-being of its people whose reach is extended (in global influence, prosperity, territory and so forth) in direct proportion to the success of all of the above.

As long as human history has been recorded this has been so.  

Square the circle of population growth and you can perhaps square the circle of sustainable growth but, and I overgeneralise of course, oddly enough, those most likely to expound upon the virtues of sustainability, even negative growth, are also those who will, in my part of the world, be those most likely to push the sort of multiculturalism of the sort that accepts, in an otherwise purely secular society founded on equality, women wearing a burkha in a public square or otherwise treated as second class citizens. And we all know that one of the most likely precursors to sustainable populations (short of PRC-style force, which of course these people also tend to eschew) is women's equality, particularly (but not exclusively) via education.


The Hun is always either at your throat or at your feet. Winston Churchill

by r------ on Tue Apr 20th, 2010 at 05:07:19 PM EST
It is quite a "spiritual" failure of the Soviet experiment that they did not come up with other aspirations. The egalitarianism was decent, though apparently not valued by the citizen - consumer materialism was somehow the highest value there as well.

But overpopulation problems could be overrated - and women emancipation is indeed a good factor. The West was never (objectively) close to overpopulation drama. Growing cities and population density only meant higher production and generally better life quality. People were suffering not because of lack of potatoes or something.

by das monde on Wed Apr 21st, 2010 at 07:20:14 AM EST
[ Parent ]
The question isn't so much how many people we can fit on the planet as it is how comfortable they will be.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Wed Apr 21st, 2010 at 12:05:05 PM EST
[ Parent ]
The comfort is arguably still increasing. When do you want to short the comfort growth? :-)
by das monde on Wed Apr 21st, 2010 at 10:34:59 PM EST
[ Parent ]
Alive and healthy CAN BE comfortable.

We haven't been trained to it yet.

Women don't naturally want unlimited children.

ACCESS to children, maybe. The village provides.

Hilary Clinton was right.

Align culture with our nature. Ot else!

by ormondotvos (ormond.otvosnospamgmialcon) on Thu Apr 22nd, 2010 at 06:46:21 PM EST
[ Parent ]
So I have a discount rate of 9%, and a growth rate of 10%.  Then I have present value of -CF/1% ? and if I manage to match my growth rate to my discount rate I have infinite money?  (I'm obviously missing something important here)

(I presume the CF/r comes from the geometric series)

by njh on Thu Apr 22nd, 2010 at 06:56:10 PM EST
It assumes that the growth rate is less than the discount rate.

If the growth rate is greater than the discount rate, the series does not converge.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Thu Apr 22nd, 2010 at 07:25:13 PM EST
[ Parent ]
..Things like the beautiful view from the mountain-top house..  ..is not put into the equation..

On the contrary. The beautiful view from the mountain-top is the whole equation in the housing market. The rental value of location. No "investor" is interested in bricks and mortars. They are costs and lose value every year.

by kjr63 on Fri Apr 23rd, 2010 at 07:27:25 AM EST
well, only indirectly if you can charge a higher rent (if you are buying to rent to someone else) because of the vista. If a house has a better view but can only be rented for less because e.g. it is has really old heating installed, then investor will chose the not so nice vista house because it gets a higher rent.
by crankykarsten (cranky (where?) gmx dot organisation) on Fri Apr 23rd, 2010 at 11:42:11 AM EST
[ Parent ]


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