Friday, March 16, 2012

Thinking rationally about growth

It is not uncommon for a fast-growing company to get overvalued by the market. And as we all know, investing in overvalued stocks is never a good recipe for attractive long-term returns. Sure, growth is great, but how do we take a company’s revenue and profit growth rate into account when valuing that company’s stock?  This article will give you my take on valuing growth companies:

I usually treat growth as a bonus, and value a growth company based on its current profitability. In other words, I would value a growth company just like how I would value any other company. However, there is value in the company’s growth, and I will account for that value by requiring a smaller discount to intrinsic value before investing in the stock (Benjamin Graham’s margin of safety concept states that stocks should be bought at a discount to their intrinsic value to reduce risk). One of the best ways to reduce risks is to earn more money; that’s my rationale for requiring a smaller discount to intrinsic value if the company is growing earnings at a good rate.

It’s only in the case of a very attractive company (both high growth and excellent returns on equity) that I might consider paying a higher valuation than what the company’s current profitability would suggest as appropriate. In this type of situations, I will look to the price/earnings to growth ratio that Peter Lynch popularized. The PEG ratio is basically the P/E ratio divided by the growth rate. As a general rule, you only invest in the stock if its PEG ratio is below 1. Example of the PEG ratio in action: If company Awesome Inc. has a P/E ratio of 15 and an estimated annual growth rate of 20%, then its PEG ratio would be 0.75 (15/20 = 0.75) which seems pretty good.

I don’t project growth into the future by plugging in a growth component when discounting future cash flows because you need both expert knowledge of the industry and the company to make any reliable estimates of growth. Even then I’m doubtful that someone can accurately predict the company’s growth rate far out into the future (you need to have a timeframe of at least 10 years if you want to be a serious long-term investor). For people without good knowledge of the company and the industry, adding a growth component when discounting future cash flows is dangerous in the sense that they can drastically overvalue the company.

It’s important to remember this point on growth made by Warren Buffett that growth is only good if the company can achieve good returns on capital. There’s a long-term adverse impact on shareholders’ wealth if the company retain earnings and load up on debt to pursue growth opportunities that yield subpar returns. So, when thinking about a company’s growth rate, don’t forget to look at the company’s return on equity and whether or not it has a durable competitive advantage (at the end of the day, a company can only sustain good returns on capital if it has a durable competitive advantage).

If you have any questions or have anything that you would like to share, please feel free to comment or send me a private message.  Thank you for reading, and may you always sustain good returns on your portfolio. Take care.