Vicentiu Covrig 1 Growth Stock Investing (chapter 12)

Vicentiu Covrig 2 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 Revenue—top line growth - Generating sales growth EPS Growth—bottom line growth - Most investors care more about profits than sales…

Vicentiu Covrig 3 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.

Vicentiu Covrig 4 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

Vicentiu Covrig 5 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:

Vicentiu Covrig 6 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.

Vicentiu Covrig 7 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

Vicentiu Covrig 8 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:

Vicentiu Covrig 9 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:

Vicentiu Covrig 10 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.

Vicentiu Covrig 11 Thinking about growth rates Internally sustainable growth - How fast can the firm grow with internally generated funds: where or

Vicentiu Covrig 12 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

Vicentiu Covrig 13 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.