Computerized Investing - Spreadsheet Collection/Spreadsheet Collection.iso/pc/ibm9/growstk.doc

Text File | 1991-07-11 | 5.8 KB | 130 lines

A Quick Model for Valuing Growth Stocks
By Fred Shipley, Ph.D.
Computerized Investing, May/June 1989

     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.

(c) Copyright 1989 by the
American Association of Individual Investors