Growth Stock 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…
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
- Growth stocks are immune from regulation.
Vicentiu Covrig Pitfalls to Growth
Customer Loyalty Risk
- There is often very little loyalty in new and rapidly
- 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
• Regulation Risk
• Price Risk
– Good company, price too high
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
D1 D2 D n Pn
1 k 1 k 2
1 k n
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.
D 1 g1 1 g 2
D0 1 g1 0
D0 1 g1 D0 1 g1 D0 1 g1 k g2
1 k 1 k 2
1 k 3
1 k n
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?
1.501 0.25 1 0.08
1.501 0.25 0.10 0.08
1 0.10 1 0.102
1.875 0.02 1.705 106.534 $108.24
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
t 1 1 k t
- Less the debt:
Market Value of Debt
# of shares # of shares
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.
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
The constant growth rate model of equation is used to determine the terminal cash flow in
CFYear5 terminalvalue 95,978,057
3,000 ,000 3,600 ,000 4,320 ,000 5,184 ,000 6,220 ,800 95,978 ,057
1.15 1.15 2 1.15 3 1.15 4 1.15 5 $39 .82
# of shares 300,000
Growth at a reasonable price (GARP)
- P/E ratio dividend by expected EPS growth rate
If PEG ≤ 1, the stock may be worthy of investment attention and
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.
Thinking about growth rates
Internally sustainable growth
- How fast can the firm grow with internally generated
Internally Sustainable Growth Retention Rate ROE
Retention Rate 1
Dividend Payout Ratio
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
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
Financial Analyst Bias
Analysts suffer from the same
psychological biases as other investors
- Work for investment banks and brokerage
- Work for investment firms, mutual funds,