FIN639 Vicentiu Covrig 1 Growth Stock Investing (chapter 12)

FIN639 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…

FIN639 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.

FIN639 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

FIN639 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:

FIN639 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.

FIN639 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

FIN639 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:

FIN639 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:

FIN639 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.

FIN639 Vicentiu Covrig 11 Thinking about growth rates Internally sustainable growth - How fast can the firm grow with internally generated funds: where or

FIN639 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

FIN639 Vicentiu Covrig 13 Growth Stocks Appear Attractive Representativeness bias The human brain uses shortcuts to reduce the difficulty of analyzing complex information.  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!

FIN639 Vicentiu Covrig 14 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.

FIN639 Vicentiu Covrig 15 Learning objectives Discuss the characteristics of growth investing; know all the characteristics mentioned in slides 2 and 3 Discuss the pitfalls to growth Know how to calculate an intrinsic value per share using two growth rates (slide 7) Know how to calculate an intrinsic value per share using cash flows (slide 9) Discuss PEG ratio Know the retention rate and dividend payout ratio Know the formulas for P/e ratios from slide 12 Discuss the representativeness bias Discuss the financial analysts bias End of chapter questions 12.1,12.3, 12.5, 12.6, 12.7; Problems 12.1 to 12.4, 12.9, 12.12