Its unfortunate, but large financial institutions love to sell products by putting them into different categories so as to differentiate them. Most investment funds are put into three main categories; Value, Growth, and GARP. Value is often defined as securities that trade at low prices relative to their sales, earnings, or cash flow. Growth often refers to companies that are growing faster than average whether it is among its peers or within a faster growing part of the economy (e.g. Google vs. Con Edison). GARP stands for Growth At a Reasonable Price, which is self explanatory, however, its definition of “reasonable” is ambiguous.
In our previous blog posting, we stated that future earnings were a big determinant of stock prices. We also illustrated value using the very well known P/E ratio. Our example last week showed that company B was clearly the better value between the two companies, but that comparison was only in relation to each other and both had the same risk and growth rates.
Exhibit 1:
| Company A | Company B | |
|---|---|---|
| Stock Price | $10 | $100 |
| Annual Sales | $100 million | $100 million |
| Earnings per share | 10% | 10% |
| Risk | Same as B | Same as A |
| P/E | 10.0 | 6.67 |
Let’s take it a step further now and look at two completely different companies that trade at both $10 a share.
Exhibit 2:
| Company A | Company B | |
|---|---|---|
| Stock Price | $10 | $10 |
| Annual Sales | $1,000 mill. | $100 mill. |
| 5-yr growth rate | 30% | 10% |
| Earnings per share | $1.00 | $1.50 |
| P/E | 10.0 | 6.67 |
Source: Toinvest.tumblr.com
At first glance company B looks like a better value with a lower P/E ratio. But upon further investigation, we see why investors would pay 10x earnings for Company A, and only 6.67x earnings for Company B. Company A is a larger, more established company, growing at three times the rate of Company B, and it has better financing.
Exhibit 3:
| EPS forecast | Year 1 | Year 2 | Year 3 | |
|---|---|---|---|---|
| Company A | @30% | $1.30 | $1.69 | $2.20 |
| Company B | @10% | $1.65 | $1.82 | $2.00 |
Source: Toinvest.tumblr.com
Exhibit 3 shows us why Company A is the better “value”. We have already established that Company A has less risk and is likely more stable due to its large size. This in itself would make investors pay more for the stock relative to Company B. But remember what I said about future earnings. Assuming the growth rates are accurate, by year 3, Company A would out earn Company B, and at $10 per share would have a forward P/E of 4.5 ($10 divided by $2.20), which is lower than Company B’s forward P/E of 5.0 ($10 divided by $2.00). Combining all the information given, it becomes more obvious that Company A is the better value.
Conclusion:
There is no debate between growth and value because growth is a component of value. The higher the growth, the more value it adds and vice versa. The more important question becomes, what will you pay for that growth, which is a trickier question.
Tags: growth, stock selection, value