It is broadly true that growth is a very strong, if not the strongest, driver of stock valuations. However, the impact of growth depends on its source and nature. There are 4 different types of growth.
Growth due to reinvestment at cost of capital
Cost of capital refers to the opportunity cost due to the next best alternative forgone for your capital. If the reinvestment yield is equal to the cost of capital, it basically implies that every dollar of capital only earns you a dollar of marginal revenue. Growth of this nature has no value and should not affect stock price or intrinsic value.
Growth due to reinvestment at a premium to cost of capital
Reinvestment at a return higher than the cost of capital is a value-add to intrinsic value. This is the ideal form of growth that investors should seek. Conversely, if the company reinvests at an incremental return that is below the cost of capital will destroy value. Growth of such nature can be extremely misleading and dangerous. One common red flag is if a company’s growth is mainly fueled by acquisitions.
Growth resulting from a general increase in price level results in a lower multiple. This is offset by higher earnings, so unfortunately the net impact on intrinsic value is uncertain. Cost of capital increases with in line with inflation. I would think that intrinsic value remains constant most of the time. Of course, this also depends on the industry of the company. For example, consumer companies are usually able to pass on price increases to customers while the same cannot be said for REITs.
Productivity gains that result from cost control or economies of scale are a valuable source of growth. Essentially, such growth is ‘free’ as they do not require any additional investment. As such, it most certainly increases the intrinsic value of the firm.
Not distinguishing between the different types of growth is detrimental for an investor, especially if he is paying a price for it. Without being certain of the nature of growth, investors will be safer staying with low growth, value stocks.
This post brought to you by ValueEdge
Take charge of your financial well-being today! Click Here to find out how you can be a part of our Alp Investment Club.