Investments: Analysis and Behavior Chapter 12- Growth Stock Investing ©2008 McGraw-Hill/Irwin

12-2 Learning Objectives Recognize growth firm opportunities. Be able to value growth potential. Understand and identify the risks of growth. Control your own representativeness bias. Know the bias in financial analyst recommendations.

12-3 Growth Investing Growth investors look to the future.  Look for firms that will deliver increasing revenue and profits  Often found by looking a past growth Three years of above-average EPS growth Twice the earnings growth of the S&P500 High profit margins  Can the growth be sustained? Competition Capital (internally or externally funded)

12-4 Growth Indicators Revenue—top line growth  Generating sales growth EPS Growth—bottom line growth  Most investors care more about profits than sales… Dividend Growth  Only some growth firms pay dividends

12-5 Characteristics of Growth Stocks In the late 1930s, Thomas Rowe Price, founder of mutual fund company T. Rowe Price and Associates, Inc., was a pioneer of in the growth stock approach to investing.  Growth stocks display high profit margins, an attractive return on total assets (ROA), consistent earnings per share growth, and use low levels of debt financing.  Growth stocks lack cutthroat competition.  Growth stocks have superior research to develop distinctive products and new markets.  Growth stocks have low overall labor costs but pay high wages to talented employees.  Growth stocks are immune from regulation.

12-6 Focus on economic quality and business investment opportunity.  Market niche  High profit margins  High return on assets Conservative Financial Structure  Good growth firms use low financial leverage  Debt to assets: long-term debt / total assets Good growth firms grow through increased business, not through accounting/financial engineering

12-7 CompanyIndustrySymb Price P/E: 5- Year Avg. ROA: 5-YR Avg. (%) Lever age Ratio EPS Growth Next 5 Yr (%) A. Low Financial Leverage is Typical Among Highly Profitable Firms Moody's CorporationBusiness ServicesMCO Federated Investors, Inc.Asset ManagementFII Coach, Inc.Textile - Apparel FootwearCOH Apollo Group, Inc.Education & Training ServicesAPOL Adobe Systems Inc.Application SoftwareADBE Forest Laboratories, Inc.Drug Manufacturers - OtherFRX IMS Health, Inc.Business Software & ServicesRX Oracle CorporationApplication SoftwareORCL William Wrigley Jr. Co.ConfectionersWWY Avon Products, Inc.Personal ProductsAVP Colgate PalmolivePersonal ProductsCL Biomet, Inc.Medical Appliances & EquipmentBMET T. Rowe Price GroupAsset ManagementTROW MERCK AND CODrug Manufacturers - MajorMRK Waters CorporationScientific & Technical InstrumentsWAT Averages

12-8 CompanyIndustrySymb Price P/E: 5- Year Avg. ROA: 5-YR Avg. (%) Lever age Ratio EPS Growth Next 5 Yr (%) B. Low Profitability is Typical Among Highly Leveraged Firms Amazon.com, Inc.Internet Software & ServicesAMZN Goodyear Tire & RubberRubber & PlasticsGT Fannie MaeCredit ServicesFNM Lucent Technologies Inc.Processing Systems & ProductsLU Hercules IncorporatedSyntheticsHPC TXU CorporationElectric UtilitiesTXU The Bear Stearns Companies Inc.Investment Brokerage - NationalBSC Freddie MacMortgage InvestmentFRE SLM CorporationCredit ServicesSLM Goldman Sachs Group, Inc.Investment Brokerage - NationalGS Lehman Brothers HoldingsInvestment Brokerage - NationalLEH Merrill Lynch & Co., Inc.Investment Brokerage - NationalMER The AES CorporationElectric UtilitiesAES GENERAL MOTORSAuto Manufacturers - MajorGM UST Inc.Tobacco Products, OtherUST Averages

12-9 Pitfalls to Growth Customer Loyalty Risk  There is often very little loyalty in new and rapidly growing markets Merger Risk  The best growth comes from self-expansion  Less successful is the growth from acquisitions Roll-up is a company that grows through a constant acquisition binge. Regulation Risk Price Risk –Good company, price too high

12-10 Growth Models Growth firms are often difficult to value because of the fast and variable growth rates.  The constant growth rate model isn’t useful:  So, return to the more general dividend discount model:

12-11 Variable growth rates  For many growth firms, the current rate of growth (g 1 ) is very high, this rate will decline sometime in the future (to g 2 ).  When the growth rate becomes constant, you can use the constant growth rate model to value the stock at that point in the future.

12-12 Example: A fast growing company paid a dividend this year of $1.50 per share and is expected to grow at 25% for two years. Afterwards, the growth rate will be 8%. If the required rate is 10%, what is this value of this stock? Solution: Using equation

12-13 What if the company doesn’t pay dividends? Fast growing firms need capital to grow, so they don’t pay dividends. Use cash flow as a basis of value  Business value:  Less the debt:

12-14 Example: A young and fast growing company pays no dividends and none are expected in the near future. The firm will earn $3 million in net cash flow next year. This cash flow is expected to grow at 20% during the next 4 years and then grow at 8% per year indefinitely. The firm has $50 million in debt and 300,000 shares of common stock outstanding. Compute the intrinsic value of the stock using a 15% discount rate. Solution: The cash flows in the next few years will be: The constant growth rate model of equation is used to determine the terminal cash flow in year 5:

12-15 Growth at a reasonable price (GARP) PEG ratio  P/E ratio dividend by expected EPS growth rate If PEG ≤ 1, the stock may be worthy of investment attention and possible purchase. If PEG ≤ 0.5, the stock is definitely worthy of investment attention, and may represent a very attractive investment. If PEG ≤ 0.33, the stock is apt to represent an extraordinarily attractive investment opportunity.

12-16 Company Name Current P/E Analyst Estimate of EPS Growth Next 5 Yr (%) PEG Ratio Based Upon Analysts Estimates Amerada Hess Corporation Navistar International Nabors Industries Ltd D.R. Horton Inc KB Home Centex Corporation Lennar Corporation Pulte Homes, Inc Cummins Inc CSX Corporation Freeport-McMoRan Copper & Gold Inc SAFECO Corporation PACCAR Inc Ambac Financial Group, Inc MERCK AND CO INC Yahoo! Inc Capital One Financial Corp Average

12-17 Thinking about growth rates Internally sustainable growth  How fast can the firm grow with internally generated funds: where or

12-18 Thinking about the P/E ratio Note that the P/E ratio is related to growth:  Remember the constant growth rate model  Divide both sides by earnings to obtain the P/E ratio  So, higher growth firms should have higher P/E ratios  Can also write equation as

12-19 Growth versus Value S&P/Barra Value and Growth Indexes  SP500 Index firms are split by firm’s P/B ratio Higher P/B firms assigned the Growth index Lowe P/B firms are assigned the Value Index  Done in 1992, but then done historically back to 1975  Done with SP MidCap 400 and SP SmallCap 600 too!

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12-22 Year S&P MidCap 400 S&P MidCap 400 Growth S&P MidCap 400 Value S&P SmallCap 600 S&P SmallCap 600 Growth S&P SmallCap 600 Value %22.40%26.45% %13.67%13.43% %-6.98%-0.57%-4.77%-5.47%-4.52% %27.30%34.04%29.96%29.07%30.69% %18.41%19.40%21.32%16.09%26.10% %30.28%34.38%25.58%15.65%36.45% %34.86%4.67%-1.31%2.29%-5.06% %28.74%2.32%12.40%19.57%3.03% %9.16%27.84%11.80%0.57%20.86% %-7.97%7.14%6.54%-1.18%13.10% %-19.17%-10.11%-14.63%-15.36%-14.47% %30.95%40.18%38.79%37.32%40.03% %14.00%19.93%22.65%21.99%23.25% 2005*11.78%12.54%10.95%8.68%9.99%4.16% Geometric Mean14.72%13.68%15.53%12.09%9.90%13.17% Median17.00%16.21%16.42%12.10%12.82%16.98% Stand. Deviation14.11%16.43%14.95%15.43%15.26%17.76%

12-23 Growth Stocks Appear Attractive The human brain uses shortcuts to reduce the difficulty of analyzing complex information.  Representativeness bias A cognitive error where things that seem similar are assumed to be alike. Extrapolate past performance Good companies are assumed to be good investments Investors are wired to believe that the great past growth of a company will continue into the future.  Great growth can’t last forever!

12-24 Financial Analyst Bias Analysts suffer from the same psychological biases as other investors Sell-side analysts  Work for investment banks and brokerage firms Buy-side analysts  Work for investment firms, mutual funds, etc.

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