Valuation and Growth

Valuation and Growth


 Its okay to buy growth, just don't pay for it.

  Marty Whitman

This ties in closely to the idea of “Margin of Safety” and is more of a dynamic concept than most investors realize. Valuing a stock of a company depends on where the company is in its life cycle. It could be emerging growth (Micro Cap), growth (Small to Mid Cap and even Large Cap in some cases) or Value (Large Cap that has saturated its market and stopped growing). It could be a cyclical stock closely tied to vagaries of the business cycle. In my own investing my focus is on growth and  the small to mid cap area so that is what I’ll be discussing here. 

I've talked before about "buying cheap", which means buying a stock for less than its intrinsic value. The intrinsic value of a business is equal to all the cash it will generate in the future discounted back to the present time. The way I approach this problem is to focus on companies that have high rates of ROE and/ or ROIC that are currently trading at a low to reasonable P/E ratio and if they pay a dividend I want to see a low payout ratio. The pros deal with things like discounted cash flow analysis and the like but since I steal most of my ideas from the pros I don't bother with that. And I don't really believe that projecting cash flows out to 10 years in the future is a wise policy. Three years makes more sense to me. Just stick with the profitability ratios and a low P/E. I also look at Price to Operating Cash Flow as that metric has more Wager Value than the overused P/E. Operating Cash flow is also a much more difficult metric to manipulate, but use both of them when you can. Where do you see the profits of the company in the next three years? If things take off be prepared for an expanding P/E to compensate for the growth of the company. Another thing to remember is to try to use the forward P/E (based on next year's estimates) since we're dealing with growth companies.

There is more risk when investing in a emerging growth Micro Cap (under 100 million) but if you hit one that survives and prospers the rewards can be enormous. The key drivers to focus on in this area are the size of the potential market. It has to be huge to fuel the growth in revenues. As you move down the food chain in market cap, management becomes a more critical factor in the investment process. They have to manage the expenses of the growing enterprise as well as work on improving the profit margins of the company. If things grow too fast they can spin out of control very easily.  Access to capital is another key area and it helps a lot if the company has some key institutional investors behind it. and of course its needs above all a sustainable advantage over the competition in the form of patents, technology, growing network affects, distribution routes etc...

For larger growth firms (100 million to 2 or 3 billion) scalable growth with sustainable margins will come into play. you want companies that can diversify their product lines and cater to a wider customer base as they grow. Keep an eye on their profit margins. At this stage of the growth cycle revenue will begin to decelerate. The rate of deceleration will depend upon the size of the overall market for its products and services as well as the strength of the competition. The better growth companies will have their revenue growth decelerate at a slower rate. Management as always must steer the ship.

Remember focus on the profitability ratios and growing revenue streams. Are the companies adding value to their enterprise over time? When they stumble and miss their quarterly numbers, Mr Market will provide you an opportunity to make a good long term investment at a reasonable price.

A good little book covering this area of investing is The Little Book of Valuation by Aswath Damodaran.

Financial Metrics and Ratios

Financial Metrics and Ratios

I’m a growth investor with a value bent so I want to buy growth but I don’t want to pay for it. That being said I want to focus on the metrics of a company that shows me it’s growing and becoming a larger more profitable enterprise. As always I try to keep things simple. I prefer to look at the operating metrics of a company first and let things fall into place after that. The following is a list of metrics that I like to see growing over time.

Revenues

Operating Income or (EBIT, earnings before interest and taxes)

Operating Margin                               (gross profit - operating expenses)

Operating Cash Flow

Book Value per Share                          

Free Cash Flow                                     (operating cash flow – capital expenditures)

Free Cash Flow per Share

Return on Invested Capital (ROIC)

Return on Equity (ROE, the Dupont formula which breaks ROE down into three components…

1)      Net Margin                    (net income / sales)

2)      Asset Turnover              (sales / assets)

3)      Financial Leverage        (assets / equity)

I also check to see if the company has retained earnings on its Balance Sheet. This allows the company to re-invest in their business for future growth. As I prefer smaller to mid cap companies I’m looking for scalable growth. I don’t want them growing too fast although that can be a good opportunity to get into a great situation early but it also increases the risk of the company getting ahead of itself and blowing up so you have to be careful.

Don’t get hung up on the precision of the numbers, they are only there to put you in the ballpark. Remember they are based on a lot estimates and assumptions on the Income Statement and the Balance Sheet.  The numbers should be your servant not your master. Following the trend in metrics like operating income, operating margin, operating cash flow, book value per share and return on invested capital can tell you a lot about the growth prospects of a company. (cannibalizing my own stuff already)

Management is especially important in a smaller company. Not only do they have to grow the revenues of the business, they also have to control the costs and risks of growing those revenues. They are responsible for allocating any surplus capital in order to expand the business of the company as well as negotiating financing needs with third party entities.So management is important. You might want to read about the CEO, CFO and maybe about some of the directors on the board as well. Now if I could only follow my own advice.

I guess that’s all for now. This was only meant to be a quick overview of a rather large subject. I’ll post more about financial ratios in the future. The learning process never really stops once you get your nose into this stuff. But if you like it, its fun and in the end empowering as you are developing a skill set nobody can ever take away you from.

ROIC is the after tax operating income relative to the capital invested in the firm, where capital is defined as the sum of the book value of debt and equity, net of cash and marketable securities.

ROE relates profits to the equity investor (net profit after taxes and interest expenses) to the book value of the equity investment.

These are profitability ratios which show how much value management is adding back to the company over time. Probably, two of the most useful ratios in all of investing.

The growth of book value or equity per share is a key item as it shows that the value of the investment dollar of the equity holder is increasing and therefore creating additional wealth over time.

Books and Resources

The Edgar Online Guide to Decoding Financial Statements by Tom Taulli

Financial Intelligence by Karen Berman and Joe Knight

Dividend Growth Investing

Dividend Growth Investing

In my own investment portfolio I have about half of my money in the small to mid cap sector with a focus on growth stocks. The other half of my funds are in dividend growth like vehicles which tend to grow their dividend payout over time. The stocks in this part of my portfolio tend to be a little bigger but most of them still fall in the mid cap space.  The dividend growth part of my portfolio provides stability to offset the volatility of the smaller growth stocks I’m holding.

Dividend growth investing offers certain rewards but does require great patience as time is the critical factor needed for implementing the strategy. Dividend growth investing is based on the concept, ‘yield on cost’. I’ll give you an example from my own holdings. I bought the limited partnership, Brookfield Infrastructure Fund back in the summer of 2010. Being a limited partnership they pay you in distributions rather then dividends due to the structure of being a Master Limited Partnership. The payout that summer was $1.40 per share. Since I bought this Brookfield holding they have raised the distribution repeatedly. Presently I am receiving $2.28 per share on my holdings, so my yield on cost is 10.23. Yield on cost is the return you are getting on the book value of your original investment. In a world of low and even negative interest rates, it is very re-assuring to hold an investment that is yielding 10.23 on my original cost and this isn’t even considering the capital gains I have realized from the appreciation of the underlying stock.

Some thoughts to bear in mind when a company constantly raises their dividend over time…

An instrument that produces income is valued based on the amount of income it produces and if it produces more income, it is worth more, so not only do you benefit from a rising income stream but the value of the underlying equity will increase over time as well.

The management of a company has to allocate capital to expand the business, and invest in research and development so if on top of that they still have the money and the confidence to pay their shareholders a rising dividend over time, its telling you something good about the future of the business.

Management are shareholder orientated in that they are returning money to their investors.

As the dividends are paid out from the earnings of a company those earnings must be legitimate and not doctored up in any way.

As a general investing strategy this is hard to beat and is as good as any and probably better than most but it does take patience and discipline. You really have to buy into the strategy hook line and sinker. And you have to believe in the companies you are investing in over the long haul. To invest in this strategy you will certainly have to extend your time frames and holding periods but that’s probably good advice anyway due to the short term emphasis people put on the stock market. Wager value again.

Douglas Kee is one fund manager who appears on BNN’s Market Call talk show at times. He specializes in this area of investing and is worth listening too.

A great book on this approach to investing would be The Single Best Investment by Lowell Miller.