Growth Stock Investing

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Chapter 10

• Growth Stock Investing

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CHAPTER 10 OVERVIEW

• 10.1 Growth Stocks
• 10.2 Growth Stock Characteristics
• 10.3 Pitfalls to Growth
• 10.4 Discounted Present Value
• 10.5 Divided Discount Models
• 10.6 Growth Stock Investment Strategies
• 10.7 Is AOL a Growth Stock?

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KEY TERMSGrowth Stocks

• Growth Stock Investing
• Value Investing
• Economic Value
• Market Niche
• Financial Engineering
• Customer Loyalty Risk
• Merger Risk
• Roll-up
• Regulation Risk

• Price Risk
• Discounted Present Value / Actual Economic Value
• Expected Values
• Risk-adjusted Discount Rate
• Total Return
• Dividend Discount Model
• Constant Growth Model / Gordon Growth Model

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Equity Investment Strategies

• Growth Stock Investing
• Investment approach that focuses on companies
  expected to have above-average rates of growth in
  earnings and dividends
• Seek securities selling for prices below the
  value of future growth opportunities

• Value Investing
• Investment approach that concentrates on
  securities considered to be temporarily
  undervalued or unpopular for various reasons
• related to contrarian approach
• Seek securities selling for prices below the
  economic value of assets in place

• Investors seek bargaining selling at prices below
  their actual economic value.
• economic valuevalue determined by economic
  prospects

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Criteria for Growth Stock Candidates

• 3 or more consecutive years of above average
  growth in EPS and revenues
• High profit margins and projected earnings
  increases of 10-15 for 3-5 yrs.
• Earnings growth at twice the rate of average
• Can company sustain rapid growth prudently?
• Sufficient resources to finance future growth?
• Ideally, sufficient funds for above-average
  growth from retained earnings.
• Cannot self-finance? healthy balance sheets with
  equity levels at least twice the level of debt.
• Avoid companies with burdensome levels of debt
  financing
• Management quality, compensation
• Managers cope with rapid growth?
• Management and employee compensation plans in
  place provide incentives for high margin growth?

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Seeking Opportunity

• Growth Stock Investors
• favor aggressive companies that sell at premium
  P/E ratios
• consider dividend income secondary
• accept larger levels of risk? above-average
  long-term investment results
• focus first on companys external economic
  environment
• Fast-growing economic sector? Large and small new
  entrants diminish or eliminate future profit
  opportunities?
• pinpoint source of recent and expected earnings
  growth
• Rising sales and earnings ? Higher profit margin
  if Rising sales and earnings ? stagnant or
  falling profit margin ? negative implications for
  future growth
• watch closely for negative implications for
  future growth, including financial maneuvering

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Growth Stock Characteristics

• According to growth stock guru T.Rowe Price,
  growth stocks
• feature high profit margins, attractive return on
  total assets, consistent EPS growth, low levels
  of debt financing
• lack cutthroat competition
• have superior research to develop distinctive
  products and new markets
• have low overall labor costs but give talented
  employees wage incentives
• are immune from regulation

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Growth Stock Characteristics

• Phillip Fisher
• Buy the best companies in the best industries
• Advocate an investment portfolio as few as three
  to five well-chosen industry leaders
• T. Rowe Price
• Buy the best companies in the best industries
• Advocate broader diversification and often
  include as many as 20-25 individual positions

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GROWTH STOCK INVESTINGDefining Characteristic

• Focuses first and foremost on inherent economic
  quality of investment opportunities

• Most successful growth stock investors buy and
  hold for long termfew sell decisions, low
  portfolio turnover

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Growth Stocks Competition

• Companies in viciously competitive markets can
  seldom maintain long-lasting above-normal
  returns.
• Such sustainable above-average growth is more
  likely for distinctive industry leaders in
  competitive environments with
• attractive growth
• lucrative profit margins
• significant barriers to entry
• Successful growth relies on niche marketing
  market segments that companies can exploit
  through special firm capabilities.
• Avon Products, Inc Templeton Group of mutual
  funds)

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Growth Stocks Financial Structure

• High profit margins and ROA free firms from need
  to raise debt or equity financing.
• Ongoing need to raise equity capital
• dilutes current shareholders equity positions
• makes above-average EPS growth difficult
• Debt financing magnifies problems during
  downturns.
• Both long-term and short-term debt pose problems

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LEVERAGEA Double-Edged Sword

• Financial Engineering sophisticated manipulation
  of balance sheet using exotic debt and equity
  financing
• Financial leverage (debt financing) cannot
  transform mediocre firms into high-growth
  prospects

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PITFALLS TO GROWTH

• Customer Loyalty Risk chance of losing customers
  to established competitors of new entrants
• Fast-growing market ? do not need fear the
  problem of overcoming long-established customer
  loyalty ? customer loyalty risk is (high or low)
  and market share stability is (high or low)
• EX Digital Equipment, Apple? Dell, Compaq
• Merger Risk economic loss stemming from failure
  to achieve merger benefits like economies of
  scale or scope
• Wal-Mart, Coca-Cola ?Growth is inherent to the
  firm
• Risk for growth form merger Key employees leave
  following a merger or acquisition ? form the
  basis for new and vibrant competitors ? growth
  through merger and acquisition seldom leads to
  durable long-term business success or investor
  prosperity

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PITFALLS TO GROWTH

• Roll-up company that grows only through constant
  acquisition using financial engineering
• Use highly valued stocks as cheap currency to buy
  smaller companies ? produce a continuing boost in
  EPS Risk when stop constant acquisition ?
  companies often fail to operate efficiently
• EX Waste Management, Inc. Stop acquisitions?
  not operating efficiently ? stock prices decline
• Important Lessons (1) Growth from superior
  capabilities innate to the firm? basis for
  sustainable above-average investor returns (2)
  Growth depends on beneficial mergers and
  acquisitions? loss occurs
• Regulation Risk chance of investor loss due to
  burdensome government rules and regulations
  (e.g., health care aging population ? demand for
  health care services grows over time regulation
  changes (eg. cost-containment)? investors in the
  health care sector suffer )
• Growth stock guru T.Rowe Price, growth stocks ?
  immune from regulations minimize regulation risk

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PITFALLS TO GROWTHPrice Risk

• Price Risk chance of overpaying for attractive
  companies
• No one approach to growth stock investing gives
  clear guidanceleaves investors with a lack of
  strict buying/selling discipline
• Key question How to appropriately value growth
  stocks?

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KEY TERMSPricing Growth Stocks

• Investment rule of thumb
• PEG ratio
• growth-at-a-reasonable-price investors
• retention rate
• dividend payout ratio
• upticks
• downticks
• technology stocks

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DISCOUNTED PRESENT VALUEGrowth Stocks

• Discounted Present Value current worth of future
  flows after adjusting for risk and the time value
  of money real economic value of one share
• Expected Values anticipated amounts of stock
  prices and dividend payments
• Risk-Adjusted Discount Rate investors required
  return, signified by k
• EV after holding for one year

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Anticipating Total Returns

• Formula extended to n time periods

• Same as future return for bonds, but dividends
  less predictable than interest payments (P398,
  Table 10.4)

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DPV for Dividend-Paying Stock

• Introduce Greek letter-?
• Expected rate of return for the overall market is
  13, consisting of an 8 risk premium and a
  risk-free rate of 5 (rate of return for the
  overall market 13 risk -free rate 5 market
  risk premium 8 )
• Overall market ?1
• Individual stock
• ?1 ? have a market-like risk expected rate of
  return overall market rate of return
  therefore, it should be ______
• ?2? twice as risky as the overall market ?
  command twice the overall markets risk premium
  the required rate of return risk-free rate 2
  markets risk premium ____ 2 ___ ___
• Problem Expected rate of return for the overall
  market is 15 and a risk-free rate of 5 Find
  the required rate of return for the following
  stocks based on the ? provided
• BBB stock with ?3 ? the required rate of return
  risk-free rate ___ markets risk premium
  _____ ____ _____ _______
• CCC stock with ?1.25 ? the required rate of
  return risk-free rate ___ markets risk
  premium _____ ____ _____ _______

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DPV for Dividend-Paying Stock

• Problem
• GE with ?1.25, the EPS is 3.7, EPS growth rate
  is 14, dividend yield is 1.3, expected P/E
  ratio is 25
• Expected rate of return for the overall market is
  13, consisting of an 8 risk premium and a
  risk-free rate of 5
• Find the expected EPS in five years? (3.7)
  (1____)5 _____
• Find the expected stock price in 5 years? P EPS
  (P/E) ____ _____ ____
• Find the required rate of return for the
  stockholder?
• the required rate of return risk-free rate ?
  markets risk premium ____ __ ___ ___
  
• Based on the expected stock price in 5 years
  calculated with the appropriate discount rate,
  whats the price today?
• Since only the future price is used here, the
  discount rate should consist of only the capital
  gain part, that is, the dividend yield should be
  subtracted from the required rate of return ? the
  discount rate _____ - _____ ____
• The price today is P5/ (1 ____)5
  ________

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End-Of-Chapter Questions 2

• Problem
• MBI has a current price of 36, an expected
  dividend per share of 0.90, expected EPS of
  5.50, expected EPS growth of 10 per year and a
  typical P/E ratio of 13.5. According to the
  discounted present-value model, what is the
  expected rate of return on MBI over the next five
  years?
• Find the expected EPS in five years? (5.5)
  (1____)5 _____
• Find the expected stock price in 5 years? P EPS
  (P/E) ____ _____ ____
• Find the required rate of return for the
  stockholder?
• The price today is P5/ (1 k)5 ? 36 _____ /
  (1 k)5 ? k _______
• Since only the future price is used here, the
  discount rate here only consists of the capital
  gain part, that is, the dividend yield should be
  added back to get the required rate of return ?
  the the required rate of return k dividend
  yield _____ _____ ____
• Dividend yield D/ P ____ / _____ ______
• The answer is _______

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Dividend Discount Models

• Approach used to value stocks based on dividend
  income and risk considerations
• Variable Growth Model
• present value of all future dividends in
  perpetuity
• capital gains explicitly incorporated in model,
  capturing influence of stock appreciation by
  virtue of dividend forecasts
• model difficult to apply--requires precise
  estimates of annual dividends for entire period

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DIVIDEND DISCOUNT MODELSConstant Growth Model

• Simplified model with constant rate of growth
• Sometimes called Gordon growth model
• P0 D1/(k-g)

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Table 10.5
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End-Of-Chapter Questions 4

• Problem
• BEN has a current price of 36, is expected to
  pay a dividend per share of 0.25 next year, and
  grow dividends at a rate of 15 for the
  foreseeable future. According to the dividend
  discount model, what is the required rate of
  return for BEN investors?
• Constant Growth Dividend Discount Model ? P0
  D1/(k-g) k (D1/ P0)g
• Here P0 _____, D1 ____, g _______
• k
• The answer is _______

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Growth Stock Investment Strategies

• Investment Rule of Thumb simple guide to
  investment valuation that has served test of time
• PEG Ratio P/E divided by expected EPS growth
  rate
• PEG? 1? worthy of attention and possible purchase
• PEG? 0.5? definitely worthy of attention, a very
  attractive investment
• PEG? 0.33? an extraordinarily attractive
  investment opportunity
• Growth-at-a-Reasonable-Price Investors
  disciplined growth stock investors who seldom buy
  growth stocks with PEG ratios greater than 1
• Effectively use PEG ratio approach ? find
  effective means for predicting EPS ? Growth rate
  ROE Retention Rate
• Retention Rate share of earnings retained to
  fund investment 1-(Dividends/ Income)
• Dividend Payout Ratio (b) percentage of income
  paid out in the form of dividends
  (Dividends/Income)
• P/E b/(k-(1-b)ROE)
• Holding all else equal, P/E ratio will fall with
  an increase in the (b, k, ROE)
• Holding all else equal, P/E ratio will rise with
  an increase in the (b, k, ROE)

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Momentum Strategies

• Popular with daytraders and short-term
  speculatorsworks in bull markets
• High volume on upticks
• Low volume on downticks
• Momentum-based strategists are minority on Wall
  Streetprofessionals usually focus on fundamentals

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Technology Stock Investing

• Companies at vanguard of important new
  innovations
• Computers, portable communication devices, cell
  phone technology, digital cameras, video disks,
  Internet (dotcoms)
• Returns good during expansions, but risks also
  huge as companies try to anticipate and adapt to
  new challenges