Growth Vs Value kcchongnz

Some people may wonder why I emphasize in value, value and value and not growth, growth and growth in investing. Is growth investing separable from value investing?

A firm with a higher growth will grow its earnings at an accelerated rate compared to a low growth firm. Assuming a firm A earns 10 sen a share a year now and it pays no dividend, with all its earnings reinvested into the business with the same return. Assuming its earnings grows at 10% a year. In 5 years time, its EPS will grow to 16 sen (10*(1+10%)^5).  If the growth rate is 30%, EPS after 5 years will be 37 sen, more than double that of the growth at 10%. Table 1 below shows the EPS at different growth rate.

Table 1: Earnings growth rates

So shouldn’t a stock with higher expected growth rate sell at a higher valuation? Of course it should, but that is only the first-level thinking. But one needs second-level thinking; that is how much higher should it be? This still brings us to the concept of value investing, value, value and value; that “The value of a firm is the sum of expected future cash flows generated by the firm discounted to the present value”.

Assuming stock A above is selling at $1.00 and hence at a PE ratio of 10. Let’s say my required return investing in A is 10%. In 5 years time A’s EPS grows to 16 sen. Further assume that A is still selling at a PE of 10 in 5 year’s time, or $1.60. The present value of this future cash flow is also $1 (1.6/(1+10%)^5). So if you have bought the share at $1, you are paying a fair price. If you pay 1.50 for the stock now, or at a PE of 15, you are paying a high price; but you pay 50 sen for it or at a PE of 5, you got a real bargain.

Now let us look at a stock B with present EPS of 10 sen also but a high expected growth rate of earnings of 20%. Its EPS will grow to 25 sen in 5 years time. Assuming you pay a higher price at $2 to buy B now, or a PE of 20 and after 5 years, it is still selling at a PE of 20, the price then will be $5.00 (20*0.25). If you discount this price at 10% back to the present value, it is $3.10, more than 50% above the price you pay. You got a great deal even if you pay a higher price of PE of 20 for a stock B growing at 20% for the next 5 years. Table 2 below shows the effect of growth rate and PE ratios on the fair prices of stocks.

Table 2: Effect of growth and PE ratio on stock prices

We have seen that it is justified to pay a higher price for stock B which has a higher growth than A. If investors see the consistency of the growth in B, they may be willing to pay a higher valuation for it 5 years later. As shown from Table 2, if the rate of growth is maintained at 20%, and valuation expanded to a PE of 30, the present value of stock B is worth $4.64.

The problem is the “growth” we are talking about is the future expected growth, a forecast figure which is very difficult to predict. The growth estimate, especially those with very high rates often does not last long enough to justify the high PE.  In the case of stock B, if the forecast growth rate is lower than expected, say at 10%, instead of 20%, and that the PE ratio contracted to 15 as a result, investors who have paid $2.00 initially would have its present value dropped to $1.50 as shown in Table 2. Even analysts got their forecasts wrong most of the time. So how good is yours?

There were numerous studies about the returns of the growth and value strategy and the results of all studies were consistent.  Value investing strategies outperformed growth strategies.  This held true regardless of which variable was used to identify value stocks.  Variables that were used to identify value stocks included price/earnings, price/book value, price/cash flow, price/free cash flow and dividend yield. 

Although growth stocks initially experience higher growth rates than value stocks, the growth rates of both quickly revert toward the mean.  When investing in stocks, investors demonstrate over-optimism for growth stocks and over-pessimism for value stocks.  Several researchers expect the value investing advantage to continue, based upon the persistent nature of human behaviour.

KC Chong (26/1/14)