Always make decisions based on what you have learned and act on the facts that you have gathered. Even if you turn out to be wrong, at least you can learn from your own mistakes.” Mark Mobius, Templeton Global Fund.

Previously I posted on the Petersburg Paradox of using high, perpetual growth rates in financial models like Discounted Cash Flow (DCF) here: http://wp.me/p2OaYY-1p6.

If next year’s owner earnings will be $1 per share or a total dividend payout of $1 with a cost of capital of 10% for the business, then we will theoretically pay $10 per share for the company. If the company will grow forever more at 5%, then we will pay $20 (10% cost of capital minus perpetual growth rate per year of 5%) divided into $1 = $20 per share. If the growth rate is 10% then we will pay “any” price. Of course, common sense should stop you right there.

Nevertheless, you often see high growth rates of 12% or 15% or more predicted by analysts. What are the probabilities of a company growing its earnings at 15% per year for decades? The article below discusses the snare of earnings management, but the article includes a study of how few (2%) of all major companies have grown their earnings at a 15% rate. This is another warning to be careful of forecasting or expecting rapid growth.

The 15% Delusion

……That’s the problem for big companies: The growing gets hard, and we have two studies to prove it. The first was done a few years ago by Wharton School professor Jeremy Siegel for his book Stocks for the Long Run. Siegel’s primary purpose was to examine how the Nifty Fifty of 1972 would have treated investors who paid the sky-high prices then being asked for them and held on for 25 years–and the answer was “not badly.” But a secondary part of the study looked at the group’s annual growth rates in earnings per share. And only three companies out of the 50 beat 15%. They were Philip Morris, at 17.9%; McDonald’s, at 17.5%; and Merck, at 15.1%.

The second study is one FORTUNE, working with Value Line, did for this article. For three different periods–1960-80, 1970-90, and 1980-99–we examined earnings-per-share growth for 150 large companies. In our sample were the 150 publicly owned companies that (a) at the start of each period were the biggest in the FORTUNE 500 or were in the very top of the “Fifties” lists that we used to do for certain industries, such as commercial banks; and (b) were still independent beings at the end of the period being studied. The fact that we threw out any company that did not last the period (because it was acquired, perhaps, or subjected to a leveraged buyout) gives the results an upward, “survivorship” bias. Beyond that, we know retrospectively that there was no shortage of business opportunity in the years we studied: Though the companies looked big to the world as each period began, they still had plenty of room to grow.

And yet the number that managed to increase their earnings per share over the periods by 15% annually was very small, even when you include the companies that hit the mark because of an oddball situation. For example, Boeing beat 15% in two periods (1960-80 and 1970-90) because it moved from hard times in the base years to prosperity in the later years. Similarly, Fannie Mae had an extraordinary 32% growth rate for the 1980-99 years because it began the period in a near-bankrupt condition, brought on by sky-high interest rates, and later got rich.

Read more: http://money.cnn.com/magazines/fortune/fortune_archive/2001/02/05/296141/index.htm or for a PDF of the article: The 15 Percent Delusion by Carol Loomis

More articles to make you think about the investment requirements (and risks) to drive growth.

Fallacy of Growth_Goupon

Asset Growth can lead to lower stock returns_Research Darden School

Growth Illusion

Higgily Piggly Growth and Low PEs

For the next post we will read about what Graham has to say about growth investing.

Ben Graham, the Growth Stock Investor

Every investor would like to select the stocks of companies that will do better than the average over a period of year. A growth stock may be defined as one that has done this in the past and is expected to do so in the future.[1] Thus it seems only logical that the intelligent investor should concentrate upon the selection of growth stocks. Actually the matter is more complicated, as we shall try to show.

It is a mere statistical chore to identify companies that have “outperformed the averages” in the past. The investor can obtain a list of 50 or 100 such enterprises from his broker. Why, then, should he not merely pick out the 15 or 20 most likely looking issues of this group and lo! He has a guaranteed-successful stock portfolio?

There are two catches to this simple idea. The first is that common stocks with good records and apparently good prospect sell at correspondingly high prices. The investor may be right in his judgment of their prospects and still not fare particularly well merely because he has paid in full and perhaps overpaid for the expected prosperity. The second is that his judgment as to the future may prove wrong. Unusually rapid growth cannot keep up forever; when a company has already registered a brilliant expansion, its very increase in size makes a repetition of its achievement more difficult. At some point the growth curve flattens out, and in many cases it turns downward.

…to be continued