Investments: Analysis and Behavior

1. Investments: Analysis and Behavior Chapter 12- Growth Stock Investing

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.

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)

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

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.

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

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

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:

11. 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.

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

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:

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:

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.

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

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

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!

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!

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.