High Growth = High Return?

High Growth = High Return? It is only true if

1. Higher growth translate to higher value
2. The growth expectation have not been incoporated to the stock price.

How to estimate growth?

• Investors tend to estimate expected growth by looking at its past, or expected growth in earnings in the future.
• This estimation is divorced from the operating details of the firm
• The soundest way is to make it a function of how much a firm reinvests for future growth and the quality of its reinvestment.
• Expected growth rate in Equity income, g = Retention ratio  x Return on Equity (ROE)

Value Creating Growth vs Value Destroying Growth

•  From above Equation
• Retention ratio = g / ROE
• Payout Ratio = 1 - Retention ratio
• Based on Gordon constant dividend growth model,
• Value of Equity = (Net Income x Payout Ratio)/(Cost of Equity - Expected Growth Rate)
• Click here to see the calculation in spreadsheet
• E.g. of A non value creating growth; ROE = 10%, Cost of Equity = 10%, NI = 100M
• If company growth @ 5%, 
• Retention Ratio = g/ROE = 5%/10% = 0.5
• Payout Ratio = 1 - Retention Ratio = 1 - 0.5 = 0.5
• Value of Equity = (100M x 0.5)/(10% - 5%) = 1,000M
• If company not expected to growth at all
• Retention Ratio = 0/10% = 0
• Payout Ratio = 1
• Value of Equity = (100M x 1)/(10% - 0%) = 1,000M
• The growth in this firm doesn’t add value to the shareholders.
• If growth increases earnings, why is it not affecting value?
• E.g. of A value creating growth, ROE = 15% (instead of 10%),  Cost of Equity = 10%, NI = 100M
• If company growth @ 5%, Value of Equity = 1,333 M
• If company not expected to growth at all, Value of Equity = 1,000 M
• The growth now increases the value of equity due to higher ROE than cost of equity.
• E.g. of A value destroying growth, ROE = 6% (instead of 10%),  Cost of Equity = 10%, NI = 100M
• If company growth @ 5%, Value of Equity = 333 M
• If company not expected to growth at all, Value of Equity = 1,000 M
• The growth now reduces the value of equity due to lower ROE than cost of equity.
•  Return of Equity (ROE) vs COE (Cost of Equity)
• ROE > COE will generate value for investors. 
• ROE < COE will destroy value, and at increasing rate as growth accelerates.

 Growth at Reasonable Price

• Even if a company’s growth is expected to be value generating (ROE > COE), its stock may not be a good investment if the market has overpriced growth.
• A stock with higher expected growth rate should sell at a higher valuation. But, how much higher should it be? 
• Refer to the calculation on the google doc,  the present value of a stock will be affected by it's P/E, Growth Rate, and COE
•  
• Company A 
• EPS is RM0.10 
• No Dividend (Retention Rate = 100%) - All earning reinvested to the business with same return
•  Growth 10% a year.
• Says, my COE is 10%, and I am buying to A that selling on P/E 10 (RM0.1 x 10 = RM1.00) . 
• In 5 year times, the EPS growth to RM0.10 * (1+10%)^5 =  RM 0.16 and A's P/E maintain at 10, the share price = RM1.60. 
• The Present Value = RM1.60 / (1+10%)^5 = RM1.00
• Thus, by paying RM1.00 to buy A is buying A at fair value.
•  If you pay 1.50 (PE of 15) - you are paying a high price;
• If you pay 50 sen (PE of 5) - you got a real bargain. 
• Company B
• EPS is RM0.10 
• No Dividend (Retention Rate = 100%) - All earning reinvested to the business with same return
•  Growth 20% a year.
• Says, my COE is 10%, and I am buying to A that selling on P/E 20 (RM0.1 x 20 = RM2.00) . 
• In 5 year times, the EPS growth to RM0.10 * (1+20%)^5 =  RM 0.25 and B's P/E maintain at 20, the share price = RM5.00
•  The Present Value = RM5.00 / (1+10%)^5 = RM3.10
• Thus, by paying RM2.00 to buy B is a bargain - the PV is > 50% the price you pay
• It is justified to pay a higher price for stock B which has a higher growth than A. 
• In view of the consistency of the growth in B, investor may be willing to pay a higher valuation for it 5 years later. 
• 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 “growth” is the future expected growth and it is a forecast figure which is very difficult to predict. 
• The high growth rate often does not last long enough to justify high PE. If forecast growth rate is lower than expected (says 15%) and the PE ratio wil be contracted to 15. Then the EPS = 0.10*(1+0.15)^5 = 0.20; Price @ Year 5 = 0.20 x 15 = 3.00; PV = 3.00/(1+0.1)^5 = 1.86
• Even analysts got their forecasts wrong most of the time. So how good is yours?

Conclusion

• Successful growth investing require
• to buy high growth companies with ROE > COE
• at reasonable prices
• A prudent growth investor will consider
• the magnitude of the expected growth 
• the sustainability of this growth rate (there is a tendency for high growth rates to converge towards normal level over time-and the quality of this growth).
• Investors should not only focus on the bottom-line, and pay attention to how efficient the growth is being generated.

References:-

• Growth Baby Grow kcchongnz (private)