Growth Stock Investing

1

• Growth Stock Investing
• (chapter 12)

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 SP500
• High profit margins
• Revenuetop line growth
• Generating sales growth
• EPS Growthbottom line growth
• Most investors care more about profits than
  sales

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.

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

5
Growth Models

• Growth firms are often difficult to value because
  of the fast and variable growth rates.
• The constant growth rate model isnt useful
• So, return to the more general dividend discount
  model

6

• Variable growth rates
• For many growth firms, the current rate of growth
  (g1) is very high, this rate will decline
  sometime in the future (to g2).
• When the growth rate becomes constant, you can
  use the constant growth rate model to value the
  stock at that point in the future.

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
8
What if the company doesnt pay dividends?

• Fast growing firms need capital to grow, so they
  dont pay dividends.
• Use cash flow as a basis of value
• Business value
• Less the debt

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
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.
11
Thinking about growth rates

• Internally sustainable growth
• How fast can the firm grow with internally
  generated funds
• where
• or

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

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.

14
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
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