By: Frank Armstrong, CFP, AIF
Growth stock investing is ever popular, even if unrewarding. Growth stock investors are willing to pay more than the current value for a company with higher growth potential than the market. They reason that the company will be worth much more later, and are willing to pay a premium over today’s value to obtain the additional value later.
Few investors understand the underlying theory. Even fewer successfully execute. Let’s look at both the theory that defines growth stock investing, and practical problems that confront investors in the real world. Finally, we will look at the comparative performance between growth stocks and the market as a whole over time.
The dividend discount model provides the underlying theory for growth stock investing. Let’s first admit that the following explanation is an oversimplification. For instance, we will ignore whether corporate earnings are paid out in dividends. This omission will make the academics perfectly crazy, but I argue convincingly (I hope) that it is immaterial to our discussion.
In the end, earnings are all that matters on Wall Street. Earnings give stock intrinsic value. Stocks are generally valued by the market at a multiple of their earnings. Historically, on average investors have been willing to pay between 8 and 18 times a company’s earnings to purchase stock. That multiple is referred to as the price-toearnings (P/E) ratio. Today, the S&P 500 P/E ratio is about 26, still far above historical levels.
Not too long ago, at the top of a growth/tech stock frenzy, investors were willing to pay so much more for earnings that they drove the P/E ratio for the S&P 500 into the 30s. However, many individual issues had P/E ratios far beyond those market averages.
To start our example, let’s assume a P/E ratio in the market as a whole of 20, chosen purely to make the math easier.
If ABC company makes $1 per share profit this year, investors will be willing to pay $20 per share for the stock. All other things being equal, when he makes this valuation, the investor is saying that he is happy with a 5% return barring any further growth of profit ($1/$20 = 0.05 or 5%).
Higher P/Es would imply that the investor is happy with a lower return. In economic theory at least, no investor would accept a return lower for a risky asset like stock than the local zero risk asset, which in the US is the Treasury Bill. This, in turn, puts a theoretical upper limit on P/Es. Ignore this limit at your peril.
If we project that ABC company is always going to make $1 per share, and the P/E stays the same in the economy, then the stock is always going to be worth $20 per share. Investors are unlikely to be very excited about a stock with no appreciation potential. They could buy a Treasury Bill and enjoy the same return without any risk. The price of the share most likely would fall below $20 on the market to compensate investors for the additional risk.
Growth of future share value
But, suppose we expect profits to grow at 10% per year. Earnings per share (EPS) should look like this in the future:
Then the value of the stock should grow at 10% per year also. Simply multiplying each projected EPS by 20 will give us the future value (F/V) of the stock:
Higher growth rates mean higher future values
It goes without saying that higher earnings growth forecasts would result in higher future value of the stock. At 20% to 30% assumptions, the numbers get dramatically higher. Few companies would be happy with bottom line forecast earnings increases of only 10%. Of course, these growing values are far more attractive than a stable $20 value. Successful growth stock investing starts by identifying companies that will grow faster than the surrounding economy.
The table below shows the results of projecting growth at a “modest” 20% rate. Compare the table below with the example we did at a 10% rate above. You can see that values grow to astronomical levels at high assumed growth rates over long periods of time.