Value Or Growth? Why Not Both

January 3, 2018

Value Or Growth? Why Not Both

  • Many separate value and growth investing, but they are joined at the hip.
  • Growth creates value, but it can also destroy value.
  • Today, we’ll discuss how to apply growth when calculating the intrinsic value of a stock.



Introduction

There’s a lot of talk about the difference between growth and value investing. Even I’ve compared the two investing styles when discussing academic research on the subject showing how value stocks usually outperform growth stocks. Nevertheless, academic studies always talk in general and intelligent investors can be much more sophisticated than academics.

It’s important to note that differentiating between growth and value displays ignorance, not investment sophistication. Not surprisingly, the biggest investing institutions strongly focus on differentiating between growth and value.

According to Bank of America, growth stocks are priced higher, earnings growth is higher, and growth stocks are more volatile than the broader market. Conversely, a value stock is priced lower than the broader market and is also cheaper than similar companies in the industry. Further, value stocks are described as less risky. Fidelity uses the same definitions when selling their funds.

Figure 1: Fidelity describes the two schools of investing. Source: Fidelity.

The differentiation comes from lack of sophistication as there shouldn’t really be a difference between growth and value because growth is a key component of value.

In his 2000 letter to shareholders, Warren Buffett summed it up nicely:

“Market commentators and investment managers who glibly refer to “growth” and “value” styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component – usually a plus, sometimes a minus – in the value equation.”

Therefore, the modern value investor has to implement growth as a key component of value and include growth in the calculation of intrinsic value.

What’s important to know is that growth can destroy value as well as it can create it, and that it can have a negligible or enormous impact on valuation.

Growth As A Creator & Destroyer Of Value

The differentiation between how growth both destroys and creates value is simple. Growth that destroys value burns cash and isn’t profitable while growth that creates value simply replicates a business model that works profitably with possibly similar returns on invested capital.

For example, from 2010 to 2017, Starbucks more than doubled its revenue and tripled its earnings thanks to new business venues, improved margins, and share buybacks. The return on invested capital has always been around 25%. Such returns on invested capital and growth potential have to be included in the calculation of intrinsic value, while also added to the risks related to growth which we will discuss later. Nevertheless, you have to account for such growth as value because it is, and it creates value.

Figure 2: Starbucks’ revenue and profits from 2010 to 2017. Source: Starbucks.



A company that has grown its revenue 10-fold in three years (2014-2017) is Blue Apron. However, its negative free cash flow has also grown 10-fold in the same period, clearly indicating that in this case, for now, growth is destroying value.

How To Adjust Your Calculations For Growth

Now, if you find a company like Starbucks and you want to calculate its intrinsic value, you have to be able to estimate future growth rates, something that’s impossible to do accurately. In July 2017, even Starbucks’ management lowered its long term expected earnings growth rate from a range between 15% and 20% to 12%. If you did an intrinsic value calculation in June 2017 expecting long term earnings growth of 15%, your intrinsic value calculation would be completely wrong just a month later. The higher the expected growth rate is, the higher the present intrinsic value will be where only a 100 basis point difference in growth can lead to big intrinsic value differences.

Therefore, the best way to include growth in the calculation of intrinsic value is to be conservative. For example, there is a much bigger possibility that Starbucks grows earnings 5% per year than 12% over the next 10 years. A lower than expected growth rate provides your intrinsic value with a better margin of safety. If you follow 10 stocks like Starbucks, I would bet that one of them, due to some temporary issue or negative sector sentiment, would definitely fall below a conservative growth calculation of intrinsic value. In ten years, you would find yourself with an amazing portfolio of 10 growth stocks bought at extremely low prices with a margin of safety.

The following section discussing growth risks will help you determine how conservative you should be.

What A Value Investor Has To Be Careful With When Estimating Growth

I’ve already mentioned that growth can also destroy value which is the first factor to look for in a growth story. By looking at the company’s cash flows, you can see whether value is created or destroyed for the shareholder. If there is no positive return on investment, growth is being destroyed. If there is a big possibility that the business model will create value for shareholders in the future, then one should look at margins. Margins that will likely improve with more scale lead to value creation and vice versa.

The second thing to look at are all the risks that can compromise business expansion. These risks could include market saturation, economic headwinds, higher input costs, inability for quality hires, competition, government issues, global shocks, cost of expansion capital, realistic growth ambitions, etc. The better the estimate of what can impact the company in the future is, the better your intrinsic value calculation will be.



Growth At A Reasonable Price

So perhaps the best value investments out there are the ones that offer future growth, but at a reasonable price. Companies that have healthy growth rates but valuations below the market average and a stable business model will probably deliver strong earnings in the long term even if their book values aren’t really indicating there is much value there at the moment.

In the end, it all boils down to comparing intrinsic values with conservative estimations for both value and growth.

Just to finish with the Starbucks example, if the company continues to grow earnings at 12% over the next 10 years, earnings in 2028 will be $6.2 which, with a price to earnings ratio of 15, would result in a stock price around $90. If I’m more conservative and attach a 6% growth rate, I get earnings per share of $3.58 which, with a price to earnings ratio of 15, leads to a price of $53.7 which is below the current price.