The term "growth stock" implies a company whose revenues, earnings and perhaps dividends have been growing at a rate that is rapid and unsustainable in the long run. This simple spreadsheet provides a way of evaluating such a stock, without forcing it into the constraints of the constant growth dividend model. Since the dividend valuation model involves estimating the value of all future dividends, however, we must still assume constant growth from some future time period. In this presentation, we start 10 years in the future. Given the uncertainties of forecasting earnings and dividends, 10 years seems like an adequate period of time.
This spreadsheet is useful only for a company that is paying some dividends. Similar techniques using earnings directly will be developed in the next issue. Essentially this spreadsheet determines the future value of dividends based on your estimates of growth. These dividends must be individually discounted for the first 10 years to determine their current worth. Then the value of dividends from 11 years on is calculated on the assumption of constant growth. The total of these two values is the current value of the stock.
To set up the inputs, you must estimate the company's return on its reinvested earnings. This means determining their return on equity, mostly likely from historical financial statement information. If the company has been operating for some time, you can make a reasonable estimate from historical data, as we did in the fundamental valuation spreadsheet series presented in the 1987 and 1988 issues of
CI as well as the sixth edition of the Individual Investor's Microcomputer Resource Guide.
For newer, and especially smaller companies, you might want to obtain estimates from a brokerage house, research reports, and other sources. These sources would be a good addition to any historical estimate. In particular, using a range of different sources of information will enable you to check on the validity of the estimates you derive yourself, as well as the validity of the outside estimates.
In addition, by entering initial dividends and earnings per share, the program will determine the payout ratio, and from that the earnings growth implicit in the return on equity and the percentage of earnings retained, using the formula:
g = ROE X b
where: ROE is the company's return on equity,
b is the earnings retention ratio, that is,
DPS
b = 1 - -----
EPS
and DPS and EPS are the company's dividend and
earnings per share, respectively
In our fundamental analysis spreadsheet we referred to this estimate of growth as the sustainable growth rate. That terminology is inappropriate here because the return on equity exceeds investor's required rate of return. Growth firms are able to earn more by directly reinvesting their earnings than stockholders can earn from alternative investments of comparable risk. This ability to earn more by direct reinvestment is precisely what gives rise to growth opportunities and higher valuation.
For example, a software company with copyright protection on a program has a product whose functionality may be difficult to duplicate. This difficulty makes it possible for the company to grow rapidly, gain market share and reap great profits. Similarly a drug company with a patent on a new drug has an opportunity that other companies and other investors cannot duplicate at the same risk and return.
You must next input the data necessary to determine a required rate of return. The required rate of return, r, is found using the formula:
r = RRF + Beta(Rm - RRF)
where: RRF is the expected return on a risk-free
investment, such as Treasury bills
Beta is the risk of the stock relative to the
market as a whole
Rm is the expected return on a broad measure of
stock market performance, such as the Standard
and Poor's 400 Industrials Stock Index.
(Rm - RRF ) is the expected equity risk
premium, that is the extra return offered by
the average stock.
The spreadsheet is set up so that the required return is automatically entered into cell C24 and used in the valuation. Similarly, the initial growth rate is entered into cell B24. At this point you can either copy the value of B24 to cells B25 through B33, or you can enter growth rates for each year directly. For illustrative purposes, we have chosen to enter individual year values with the growth rate decreasing in the future. This decrease in growth is a normal phenomenon, given the ability of competitors to enter the market.
Finally you must make an assessment of "normal" or sustainable long-run growth to enter into cell B34. Remember that this long-term growth figure must be less than the required rate of return. With these inputs you can determine a stock value. It is easy to do variations on your initial inputs to see the affect on price. You can window the spreadsheet (using the / Worksheet Window Horizontal command) in row 10, and then jump to the bottom window, using the F6 key, and moving the cursor so that row 39 is visible. When you jump back to the upper window, again using the F6 function key, you can change the return on reinvested earnings or the payout ratio and see the effect on value.
