Valuing Growth Shares

Expensive stocks can always become more expensive, the late 1990s are a testament to that, the late 1920s etc. In the end, companies are worth what they’re worth, the market price doesn’t make a business worth more or less after all.

If the market prices something higher when the business hasn’t become any more or less valuable, then it hasn’t become more valuable, but more expensive. When you buy a property the value goes up and down depending on what people are willing to pay for it. A business is no different. At any point in time the multiple we are prepared to pay changes. We are sitting here today saying things look expensive…but we are looking back and not forward… That’s a concern whenever stocks are tearing higher like this – businesses generally aren’t worth 10% more than a few weeks ago. There are only nine UK companies on my list that come under being an “attractive” price for my personal taste, I own three, and four of them I don’t fancy without further price reductions. 21 out of 36 trade on a multiple higher than 18.

The problem of valuing growth stocks is relatively tricky, both because you need to compare against alternatives, but also because nobody really knows the rate at which a company’s earnings will grow over 7 years.

A business is a productive asset – like a machine, or a farm (or in terms of the property example, a rental property). Their intrinsic value to an investor, is what those assets can produce over time, relative to the price paid. As to the property example, 2005-2010 surely was enough of an indication that the market price shouldn’t tell you if something is intrinsically worth more or less. No different to using the market price to tell you what the intrinsic value of a tulip was in 1637, or a tech stock in 2000 etc.

As a rule of thumb, 7-10 times earnings (10, when interest rates are low, to a minimum of 7 when they’re high) corresponds to no growth premium. That’s a 10-14% pa earnings yield on average if earnings don’t grow, but bobble around the same level, indefinitely. That will likely be double the return expected on safe corporate bonds, for assuming that extra risk of owning the equity.

So a 10 multiple for a growth stock, you could safely say, is a good price – assuming earnings don’t fall into a rapid decline, and grow as you expect. 12 would be a good price if you expected moderate growth, and you didn’t end up with indefinitely flat earnings. 15 would be a good price if you expected the company’s earnings to grow exceptionally, and the growth subsequently materialised. It’s subjective, but beyond 15, the margin of safety is thin, and stocks tends to be “fully priced”.

The market prices everything at a multiple of its normalised earnings, which reflects a certain premium for the expected growth rate in profits. Every multiple has expectations built in – as much as 2% growth for every multiple over 10, although these things are a rough, imprecise matter.

You can’t really go wrong by 1) sticking to very attractive high-return businesses with great records with shareholder money, and 2) stubbornly refusing to pay a high premium for that growth to continue. This is of course a matter of investment rather than trading though, two different rulebooks apply entirely.

Every multiple has a built in expected growth in earnings. A stock earning £1 today can be worth £200 (a 200 multiple), if you’re certain it will be earning £50 a year in a couple of years. That also applies to loss making companies – the value would be zero if you didn’t believe a profit was going to be made in future years, substantially higher than the price would suggest. Sadly a lot of investors base that on hope, or a yarn spun, rather than rational expectation.

Momentum is my sort of thing too, but that’s trading, rather than investment. The two ideas should be kept locked in boxes very separately from one another – like I say, two different rule books.