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					Vicentiu Covrig




   Growth Stock Investing
                  (chapter 12)




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Vicentiu Covrig
                          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

    Revenue—top line growth
     - Generating sales growth

    EPS Growth—bottom line growth
      - Most investors care more about profits than sales…
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Vicentiu Covrig

           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.



                                          3
Vicentiu Covrig           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


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Vicentiu Covrig
                      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                  
                            1  k 1  k  2
                                                 1  k n
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Vicentiu Covrig
     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 
                                                                                     n
                                                        D0 1  g1     0
                                                                   n

           D0 1  g1  D0 1  g1  D0 1  g1                                  k  g2
                                2               3
    P0                                         
             1 k        1  k 2
                                      1  k 3
                                                                        1  k n


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Vicentiu Covrig
  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
                                                             2
                             1.501  0.25 
                                           2
            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


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Vicentiu Covrig
    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
                                 CF
                                        V                t

                                              t 1   1  k t

      - Less the debt:
                                  n
                                        CFt
                     EV
                                  1  k 
                                 t 1
                                              t
                                                   Market Value of Debt
            P0              
                 # of shares                         # of shares

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Vicentiu Covrig
  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
                                                  6,220,800  1.08
       year 5:
                          CFYear5 terminalvalue                      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
  P0 
           EV
                   
                        1.15      1.15 2   1.15 3   1.15 4          1.15 5                       $39 .82
       # of shares                                      300,000


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Vicentiu Covrig
          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.
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Vicentiu Covrig

                Thinking about growth rates
     Internally sustainable growth
       - How fast can the firm grow with internally generated
           funds:
               Internally Sustainable Growth  Retention Rate  ROE
     where
                                        Dividends
                   Retention Rate  1 
                                        Net Income

     or
                                     Dividends
             Dividend Payout Ratio 
                                     Net Income

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Vicentiu Covrig

              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
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Vicentiu Covrig

                   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.



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posted:2/7/2013
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