Before I begin, here is a great investment myth that I would like to break, which is: ‘Dividend Investors do not Invest for Growth.’
That ain’t true.
Personally, as a Dividend Investor, I find that ‘Growth’ is a key component to my investment framework. This is because I intend to earn Growing Dividends from my stock portfolio. To do so, the stocks I had invested into should attain Growth in their businesses. If their businesses Grow, their profits should Grow, which in turn, allow these stocks to pay out Growing Dividends, which logically speaking, should result in an upward valuation of prices of these stocks (Capital Growth).
But, the question is, ‘How do we measure Growth?’
As the title suggests, the answer lies in Compound Annual Growth Rate (CAGR). In this write-up, I’ll share its definition, its method of calculating it and a couple of pointers when using CAGR.
Case Study: Apex Healthcare Bhd (AHB)
AHB is a manufacturer of pharmaceutical products in Malaysia. Over the last 10 years, AHB had recorded an overall increase in its shareholders’ earnings where it grew from RM 32.9 million in 2010 to RM 56.0 million in 2020.
So, what is the Earnings Growth Rate for AHB?
This is where CAGR comes in handy. But, before we compute it, we have to first make sure that AHB’s growth in earnings is consistent. This could be done easily by plotting a Bar Chart that depicts its 10-Year Earnings Growth as follows:
From above, we can see that AHB’s Growth in Earnings have been consistent, in general. Of course, despite its overall growth, we also could see that:
a. There was a decline in earnings in 2011 and 2019.
b. The earnings growth rate from 2011-2016 is slower.
c. The earnings growth rate from 2016-2020 is much faster.
Thus, CAGR is a formula that helps investors to quantify AHB’s overall Growth in its shareholders’ earnings over a longer period, giving us a bigger perspective in regards to AHB’s Long-Term Growth Track Record.
Next, to compute, you may read this write-up with the companion of the link to a simple CAGR calculator below:
Click Here: CAGR Calculator
3 Components to Calculate CAGR
Here, I assume that you have clicked on the link above.
Of which, we will find that the CAGR calculator requires us to input 3 things:
a. Start Value
b. Ending Value
c. Number of Periods
So, if we like to measure the earnings growth rate of AHB in 2010-2020, we will input the following:
a. Start Value = 32,942 (Earnings Figures in 2010 in RM ‘000)
b. Ending Value = 56,022 (Earnings Figures in 2020 in RM ‘000)
c. Number of Periods = 10 (Year 2020 – Year 2010)
Feel free to input these figures into the CAGR calculator. We will get:
AHB’s 10-Year Earnings Growth Rate = 5.45%
This means AHB has achieved a compound growth rate of 5.45% on its earnings per annum in 2010-2020.
By now, you may experience a ‘Eureka Moment’ and you like to head off to find yourself a couple of stocks to practise your CAGR calculating skills.
If that is you, please hold onto your horses.
I’ll pen down a couple of pointers on using CAGR:
Point 1: Past Performances Do Not Equate to Future Results
From above, we calculated that AHB’s earnings growth rate is 5.45% per annum in 2010-2020. There is no guarantee that AHB would maintain its growth rate at 5.45% per annum in the future. It may exceed it or it may fail to sustain growth.
CAGR is meant to assess the past track record of a stock.
It is like looking at students’ past examination results to determine, who exactly are academically smart and are motivated to score As in their examinations and who are not. For instance, let’s say, we have two students: Richard and Leonard and over the last 5 examinations, their results are as follow:
Richard: A, A-, A+, A, and A.
Leonard: B-, D+, C, A-, and C+.
Who do you think will be more likely to score an A for their next examination?
Naturally, if we do a pool, we would see votes Gravitated towards Richard as he has proven to be ‘a safer and consistent horse’ to bet, right?
But, we will never know the future.
Just as COVID-19 had impacted our economy, we could ‘hypothetically’ say that a schoolwide food poisoning could impact how Richard and Leonard perform in their next examination. So, let’s assume that both of them have sat through the examination with diarrhea and as a result, their results turned out to be:
Does it mean that Richard has become a ‘B-Student’ material?
I believe you get the picture. So, what I’m trying to say is: ‘CAGR is a tool, which tells about a stock’s past track record. It is not exactly a predictive tool’.
Point 2: What if My Stocks …
a. Fail to deliver consistent growth in earnings like AHB?
b. Have negative CAGR in its earnings over the long-term?
Then, you might have to ask yourself:
‘What is your purpose for buying into this stock in the first place?’
‘What value do you see in this stock?’
‘What is your motive: Is it to invest, trade, or to speculate the stock?’
Point 3: PEG Ratio
The CAGR formula is helpful to calculate a stock’s earnings growth rate.
This is a key ingredient to calculating PEG Ratio, where its formula is as follows:
PEG Ratio = Current P/E Ratio of a Stock / Earnings Growth Rate
So, back to AHB, it has recorded RM 56.0 million in shareholders’ earnings or as much as 11.84 sen in earnings per share (EPS).
Presently, AHB’s stock price is RM 2.92 a share. Thus, its P/E Ratio is 24.66 (RM 2.92 / RM 0.1184).
As calculated above, AHB’s 10-Year Earnings Growth Rate is 5.45% a year. So, if I take its current P/E Ratio of 24.66 and divide it with its 10-Year Earnings Growth Rate of 5.45% per annum, AHB’s PEG ratio is 4.52 (24.66 / 5.45).
So, is this good or bad?
Well, the idea of good or bad is kind of relative. So, an investor would then take this figure and compare it with the PEG Ratio of other stocks. Simply put, a high PEG Ratio indicates that the stock is more expensive and a low PEG Ratio would indicate that the stock is less expensive.
It is a myth that Dividend Investors do not Invest for Growth.
The key method of measuring Growth is to compute CAGR. Of which, we would then be able to compare the growth rates of stocks that we are studying and be able to do more peer-to-peer comparison by calculating their PEG Ratios. So, to end this write-up, let me just answer one last question, which is:
‘Which of the two is a priority? Is it a stock’s CAGR or a stock’s Dividend Yield?’
Personally, I would rank CAGR above Dividend Yields. For instance, if I’m given a choice between three stocks: Stock A, Stock B, and Stock C:
Stock A has 10-Year Earnings CAGR of 15% and offers 3% in dividend yields.
Stock B has 10-Year Earnings CAGR of 5% and offers 4.5% in dividend yields.
Stock C has negative 10-Year CAGR in earnings but offers 6% in dividend yields.
My first choice would be Stock A, followed by Stock B. I won’t invest in Stock C.
So, what are your thoughts on the subject of CAGR?
Maybe you can post your views by replying to this email so that we can all learn from each other.