Transcript Chapter 12.ppt

Investments: Analysis
and Behavior
Chapter 12- Growth Stock
Investing
©2008 McGraw-Hill/Irwin
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.
12-2
Growth Investing

Growth investors look to the future.
 Look
for firms that will deliver increasing
revenue and profits
 Often



Three years of above-average EPS growth
Twice the earnings growth of the S&P500
High profit margins
 Can


found by looking a past growth
the growth be sustained?
Competition
Capital (internally or externally funded)
12-3
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
12-4
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.
12-5

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
12-6
Company
Industry
Symb
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 Corporation
Business Services
MCO
61.20
27.0
37.6
3.1
15.7
Federated Investors, Inc.
Asset Management
FII
38.15
19.1
25.8
1.9
11.3
Coach, Inc.
Textile - Apparel Footwear
COH
31.75
30.3
25.6
1.3
19.1
Apollo Group, Inc.
Education & Training Services
APOL
54.51
55.1
21.4
2.1
19.8
Adobe Systems Inc.
Application Software
ADBE
38.43
40.3
21.3
1.3
13.2
Forest Laboratories, Inc.
Drug Manufacturers - Other
FRX
43.13
36.1
19.8
1.2
14.0
IMS Health, Inc.
Business Software & Services
RX
25.34
28.7
19.3
4.7
13.3
Oracle Corporation
Application Software
ORCL
12.29
26.3
19.1
1.6
12.0
William Wrigley Jr. Co.
Confectioners
WWY
65.79
31.1
18.3
2.0
10.8
Avon Products, Inc.
Personal Products
AVP
28.66
24.0
17.4
5.2
12.0
Colgate Palmolive
Personal Products
CL
53.70
27.0
16.7
8.3
9.0
Biomet, Inc.
Medical Appliances & Equipment
BMET
35.83
31.4
16.4
1.3
14.8
T. Rowe Price Group
Asset Management
TROW
75.62
22.5
16.0
1.2
12.4
MERCK AND CO
Drug Manufacturers - Major
MRK
33.25
18.6
15.8
2.5
17.3
Waters Corporation
Scientific & Technical Instruments
WAT
38.10
37.9
15.8
3.8
12.8
42.38
30.4
20.4
2.8
13.8
12-7
Averages
Company
Industry
Symb
Price
P/E:
5-Year
Avg.
ROA:
5-YR
Avg.
(%)
Lever
age
Ratio
EPS
Growth
Next 5 Yr
(%)
22.7
B. Low Profitability is Typical Among Highly Leveraged Firms
Amazon.com, Inc.
Internet Software & Services
AMZN
43.92
-13.4
472.0
Goodyear Tire & Rubber
Rubber & Plastics
GT
17.63
-2.7
54.9
Fannie Mae
Credit Services
FNM
53.21
0.7
44.9
9.0
Lucent Technologies Inc.
Processing Systems & Products
LU
2.55
-26.5
43.7
7.9
Hercules Incorporated
Synthetics
HPC
11.05
-0.6
38.4
TXU Corporation
Electric Utilities
TXU
51.44
-0.7
31.4
14.9
10.1
0.5
29.9
10.7
14.9
The Bear Stearns
Companies Inc.
Investment Brokerage - National
BSC
119.5
5
Freddie Mac
Mortgage Investment
FRE
65.91
12.6
0.7
29.7
12.5
SLM Corporation
Credit Services
SLM
55.32
21.6
1.6
29.6
16.0
Goldman Sachs Group, Inc.
Investment Brokerage - National
GS
131.4
16.5
0.8
25.9
12.5
Lehman Brothers Holdings
Investment Brokerage - National
LEH
134.8
12.5
0.6
25.2
11.9
Merrill Lynch & Co., Inc.
Investment Brokerage - National
MER
70.80
30.1
0.6
21.0
12.0
The AES Corporation
Electric Utilities
AES
17.64
-1.4
20.9
12.7
GENERAL MOTORS
Auto Manufacturers - Major
GM
20.05
0.7
20.9
4.8
UST Inc.
Tobacco Products, Other
UST
40.45
15.4
20.3
6.3
-1.6
60.6
11.8
Averages
55.72
12.3
16.3
12-8
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
12-9
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:
D1
P0 
kg
 So,
return to the more general dividend
discount model:
D1
D2
D n  Pn
P0 


2
1  k 1  k 
1  k n
12-10

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.
D0 1  g1  D0 1  g1  D0 1  g1 



2
3
1 k
1  k 
1  k 
2
P0 
3
D0 1  g1 
n
D 1  g1  1  g 2 
 0
k  g2
1  k n
n
12-11
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
1.501  0.25 1  0.08
1.501  0.25 
1.501  0.25
0.10  0.08
P0 

1  0.10
1  0.102
2.531
2.344 
1.875
0.02  1.705  106.534  $108.24


1.10
1.21
2
2
12-12
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:
n
V
CFt
t


1

k
t 1
 Less
the debt:
n
EV
P0 

# of shares
CFt
 1  k 
t 1
t
 Market Value of Debt
# of shares
12-13
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:
CF1  3,000,000
CF2  3,000,000  1.20  3,600,000
CF5  3,000,000  1.20  6,220,800
4
The constant growth rate model of equation is used to determine the terminal cash
flow in year 5:
6,220,800  1.08
CFYear 5 terminal value 
 95,978,057
0.15  0.08
3,000,000 3,600,000 4,320,000 5,184,000 6,220,800  95,978,057




 50,000,000
2
3
4
5
1.15
EV




1.15
1.15
1.15
1.15
P0 

 $39.82
# of shares
300,000
12-14
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.
12-15
Company Name
Current
P/E
Analyst Estimate
of EPS Growth
Next 5 Yr (%)
PEG Ratio
Based Upon
Analysts
Estimates
Amerada Hess Corporation
14.7
35.1
0.42
Navistar International
6.8
16.2
0.42
Nabors Industries Ltd.
23.5
49.5
0.47
D.R. Horton Inc.
8.3
15.8
0.53
KB Home
9.3
17.3
0.54
Centex Corporation
8.2
15.1
0.54
Lennar Corporation
8.8
14.6
0.60
Pulte Homes, Inc.
8.1
13.3
0.61
Cummins Inc.
9.3
14.5
0.64
CSX Corporation
12.1
16.6
0.73
Freeport-McMoRan Copper & Gold Inc.
15.9
21.7
0.73
SAFECO Corporation
10.6
14.4
0.74
PACCAR Inc
11.4
14.5
0.79
Ambac Financial Group, Inc.
11.2
13.7
0.82
MERCK AND CO INC
15.8
17.3
0.91
Yahoo! Inc.
26.4
28.6
0.92
Capital One Financial Corp.
12.9
13.6
0.95
Average
12.5
19.5
0.67
12-16
Thinking about growth rates

Internally sustainable growth
 How
fast can the firm grow with internally generated
funds:
Internally Sustainabl e Growth  Retention Rate  ROE

where
Retention Rate  1 

Dividends
Net Income
or
Dividends
Dividend Payout Ratio 
Net Income
12-17
Thinking about the P/E ratio

Note that the P/E ratio is related to growth:
 Remember
the constant growth rate model
D1
P0 
kg
 Divide
both sides by earnings to obtain the P/E ratio
P0 D1 E1

E1 k  g
 So,
higher growth firms should have higher P/E ratios
 Can also write equation as
P0 D1 E1
1- b


E1
k  g k  b  ROE
12-18
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!
12-19
Figure 12.3 Growth and Value Stocks Have Similar
Long-run Cumulative Returns
7,000
S&P 500
5,000
S&P Growth
4,000
S&P Value
3,000
2,000
1,000
Jan-05
Jan-03
Jan-01
Jan-99
Jan-97
Jan-95
Jan-93
Jan-91
Jan-89
Jan-87
Jan-85
Jan-83
Jan-81
Jan-79
Jan-77
Jan-75
Cumulative Return (%)
6,000
Year
12-20
Figure 12.4 Growth S tocks Outperformed During the 1990s, But Not Recently
40%
Growth v. Value Returns
30%
20%
10%
0%
0
1975
1980
1985
1990
1995
2000
2005*
-10%
-20%
-30%
-40%
* T hrough November.
Year
12-21
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
1992
25.14%
22.40%
26.45%
1993
13.95%
13.67%
13.43%
1994
-3.58%
-6.98%
-0.57%
-4.77%
-5.47%
-4.52%
1995
30.95%
27.30%
34.04%
29.96%
29.07%
30.69%
1996
19.20%
18.41%
19.40%
21.32%
16.09%
26.10%
1997
32.25%
30.28%
34.38%
25.58%
15.65%
36.45%
1998
19.12%
34.86%
4.67%
-1.31%
2.29%
-5.06%
1999
14.72%
28.74%
2.32%
12.40%
19.57%
3.03%
2000
17.51%
9.16%
27.84%
11.80%
0.57%
20.86%
2001
-0.60%
-7.97%
7.14%
6.54%
-1.18%
13.10%
2002
-14.51%
-19.17%
-10.11%
-14.63%
-15.36%
-14.47%
2003
35.62%
30.95%
40.18%
38.79%
37.32%
40.03%
2004
16.48%
14.00%
19.93%
22.65%
21.99%
23.25%
2005*
11.78%
12.54%
10.95%
8.68%
9.99%
4.16%
Geometric Mean
14.72%
13.68%
15.53%
12.09%
9.90%
13.17%
Median
17.00%
16.21%
16.42%
12.10%
12.82%
16.98%
Stand. Deviation
14.11%
16.43%
14.95%
15.43%
15.26%
17.76%
12-22
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!
12-23
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.
12-24
12-25
12-26