Growth is simply a calculation used to determine value.

Value is the discounted present value of an investment's future cash flow; growth is simply a calculation used to determine value.

People who consistently purchase companies that exhibit low price-to-earnings, low price-to-book, and high dividend yields are customarily called "value investors."  People who claim to have identified value by selecting companies with above-average growth in earnings are called "growth investors."  Typically, growth companies possess high price-to-earnings ratios and low dividend yields.  These financial traits are exact opposite of what value investors look for in a company.

Investors who seek to purchase value often must choose between the "value" and "growth" approach to selecting stocks.

Buffett admits that years ago he participated inn this intellectual tug-of-war*.  Today he thinks the debate between these two schools of thought is nonsense.

"Growth and value investing are joined at the hip", says Buffett.



*Comment:  It is interesting to know that Buffett too had been through these intellectual debates and then formed his own conclusions.

Why You Should Invest in Growth, Not Value

by Alexander Green, Investment U Chief Investment Strategist

Tuesday, September 25, 2012

Patrick Henry famously declared that he knew no way of judging the future but by the past.

So if you're putting together a long-term investment portfolio, it might be wise to look at the historical returns for various types of assets. Not just for the past few years, or for several decades, but for the past couple centuries...

When you do this, you'll notice something interesting:

·        Owning a portfolio of businesses (stocks) has generally been much more rewarding than making loans to corporations or Uncle Sam (bonds) or sticking your money in the bank (cash).

·        Look closer at the clear winner (equities) and you'll also find that value stocks have outperformed growth stocks over the long haul and that small-cap value has beaten large-cap value by a substantial margin.

It therefore follows that an investor seeking maximum capital appreciation might focus on identifying undervalued small-cap stocks.

But there's only one problem with this: It won't work for most investors, even if the future is very much like the past. Here's why...

Beware the Infamous Value Trap

Value stocks require something that growth stocks don't: Patience.

When a stock - either large or small - is in the cellar, it's there for a reason. Typical ones are that the company is:

·        Losing market share...

·        Seeing its margins fall...

·        Is losing money...

·        Or is experiencing flattish sales and declining profits.

As a value investor, you don't know when this state of affairs will end, but you might be tempted to invest in a company if it's relatively cheap in relation to sales, earnings, or book value (i.e. net worth) in the hope that management will set things right.

The problem is this can take quite a long time. Or it may never happen at all. As the stock gets cheaper and cheaper, you may believe it's becoming an even better bargain. This is the classic "value trap." And if you keep buying a stock on the way down, it may very well have your name on it when it hits rock bottom.

Dead Money With Decent Dividends 

Even if a value stock is destined to generate a good return over, say, a three- to five-year horizon, most investors won't be around to enjoy it.

How do I know this? Because as a former money manager, I've dealt with thousands of "typical investors." And regardless of what they say in their initial interview about their willingness to stay the course and think long term, it all goes out the window for 90% of them when the road gets bumpy. Or if things don't kick into gear right away.

A client who sits on a stock - or even a stock fund - for six months and doesn't see a spark will remind you with every conversation that he or she is sitting on "dead money."

No argument there - they are (at least temporarily). But value stocks often pay decent dividends that help compensate for this. Early in my career, however, I got tired of holding hands and counseling patience and switched from a value to a growth methodology.

It was a good move. If you want action, you should have it...

There's No Shortage of Excitement With Growth Stocks 

Buy the best growth stocks you can find. Given that they tend to be twice as volatile as the market (and twice as expensive), there is generally no shortage of day-to-day excitement.

But if you use a trailing stop, you can generate results that are much better than historical long-term returns (which always assume a buy-and-hold approach) and with less risk because your positions are fully protected.

So unless you have the patience of Job - and most investors don't - you're better off owning growth stocks than value stocks and, of course, using a trailing stop. 

Good Investing,

Alex

Use This Simple Rule to Pick Winning Shares

LONDON -- When it comes to investing, it's all too easy to get bogged down in technical details and miss the really obvious clues -- the evidence of our own eyes. I've developed a simple rule that has helped me identify goodbusinesses and steer clear of bad ones.

The original 10-baggerBetween 1977 and 1990, the U.S.-based Fidelity Magellan Fund was the best-performing fund in the world. The fund's manager during this period was Peter Lynch, the man who coined the term "10-bagger."

Lynch's record as a growth investor is second to none, and in his book One Up on Wall Street, he explains how some of his most successful investments were the result of anecdotal evidence and personal experience, rather than stockanalysts' reports.

My Lynch ruleI've developed my own version of this approach, which I've found works well for a surprising number of business: If I wouldn't want be a customer of the business, then I don't want to be a part owner of it either.

This rule made selecting some of the FTSE 100 (UKX) shares that lie at the heart of my portfolio much easier. I've written before about how virtually all of us are customers ofGlaxoSmithKline (LSE: GSK.L  ) -- a company whose products are an integral part of the fabric of modern life.

On a more mundane but no less important note, I have been a regular Tesco (LSE: TSCO.L  ) customer for years. Not only is there a Tesco Express within a short walk of my house, but there's a larger store nearby, too -- and both offer the best combination of pricing and availability in my local area. Needless to say, both stores are always busy.

Similarly, my electricity and gas come from Southern Electric -- part of dividend king SSE, while much of my diesel comes from Royal Dutch Shell (LSE: RDSB.L  ) , whose sustainable 4.8% yield and massive reserves give me confidence that the company will remain an attractive investment for decades to come.

In fact, there is only one FTSE 100 company in my portfolio that breaks my rule. I am pretty sure I will never be a direct customer of defense giant BAE Systems -- but I am fairly sure the government will continue to pay BAE a portion of my tax bill every year, which should be reflected in the company's excellent dividend record.

A sporting chanceNothing illustrates the importance of keeping your eyes open when investing more clearly than Sports Direct International (LSE: SPD.L  ) and JJB Sports.

As their updates last week showed, these two companies may be in the same business, but they are operating in completely different worlds. Both chains have large stores in the town where I live and a visit to these shops is just as educational as a look at the companies' financials.

Sports Direct is always full of stock and bustling with customers -- you always have to queue at the till. JJB, on the other hand, is a similar size shop but carries about a quarter of the stock and has very few customers. You don't need to be an accountant to work out which company is in better health.

Expert adviceOne man who knows how to identify a long-term profitable business is Neil Woodford, one of the U.K.'s most successful fund managers. Between 1996 and 2011, his stock choices rose in value by 347% -- outperforming the 42% gain of the wider market by a country mile.

Neil Woodford now manages more money for private investors than any other City manager, with a whopping 20 billion pounds of our money in his hands. In the last five years alone, his High Income fund has gained 15%, more than double the 7% return of the wider market.

The good news is that you can find all the details of eight of Neil Woodford's biggest holdings in this special free report from the Motley Fool, "8 Shares Held By Britain's Super Investor."

By Roland Head

July 23, 2012

http://www.fool.com/investing/general/2012/07/23/use-this-simple-rule-to-pick-winning-shares.aspx#.UBM2g2GO2So

The shocking truth about growth investors ... is that they are right.

The shocking truth about growth investors

Growth investing and growth investors are dirty words to many value investors.  A focus on growth is often called the Greater Fool Theory, and study after study shows that growth investing performs badly when compared to value investing.

As a value investor, it’s easy to mock growth investors with reams of data and an air of self-satisfied superiority.  There is a slight problem though.  The shocking truth about growth investors is that they’re right.  Growth investing is a fantastic way to make money in the stock market, as long as you do it right.

Warren Buffett is a growth investor

Buffett is usually considered a value investor, and that’s because he is one.  But he’s also a growth investor, and with the help of Charlie Munger they pioneered a hybrid approach where they combined the best of both worlds – long-term growth companies bought at value investment prices.

It was Buffett’s focus on outstanding businesses which could grow both quickly and consistently that really took him to the top of the world’s richest people list.

The FTSE 100 as a long-term growth investment

As a UK investor my focus is always on beating the FTSE 100 in the long-run.  The FTSE 100 beats some 80% or so of private and professional investors alike, and so if I can beat the FTSE then I know I’m doing much better than the pros, which is always nice.

I also know that my time and efforts are not wasted, because any investor can invest in the FTSE at almost no cost in terms of either time or money.  If you are not beating the FTSE 100 then you are effectively wasting your time.

As a growth investment, the FTSE 100 typically grows both earnings and dividends faster than inflation, and it does so relatively consistently over the years.  That growth ultimately drives the index level higher, regardless of how pessimistic the market may be.

In order to beat the market, we need to turn our portfolios into supercharged versions of the index, with superior growth, superior yields and superior valuations.

We all want growth, but growth of what?

For me, the most important numbers that need to grow are revenues, earnings and dividends.

At the end of the day, it’s the earnings and dividends which set the range within which a share price will fall (exactly where it falls within that range is up to the market), and both of those ultimately derive from revenues.

Long-term growth is all that matters

Short-term growth, positive or negative, is mostly noise and is unlikely to provide any useful information to investors.  If you find yourself trying to make money out of the day-to-day news then you might have inadvertently become a trader rather than an investor.

When I’m talking about growth, I mean long-term growth over as long a period as you can sensibly get data for.  For me this means looking at 10 year data for every single company that I’m interested in, and if it doesn’t have 10 years of public data available, then I won’t touch it.

This means that Facebook was out of the question, no matter how attractive it may or may not have been.

Where to get your data

Getting data that goes back 10 years can be tricky, but it is available through services likeSharelockholmes, Morningstar Premium, ShareScope and Stockopedia.

You can also get the annual results yourself and copy the information into a document or spreadsheet and use that.  I like to get annual report data from investegate.co.uk because it has a nice, lightweight and fast interface and I’m used to using it.

One slightly odd feature is that nobody seems to provide revenue per share.  We always get earnings and dividends per share, but not revenue per share.

If you want revenue per share, as I do, then you can either ask a data provider to provide it or get hold of the number of shares outstanding figure for each company you’re interested in.  Just search the annual reports for ‘shares’ and it should appear somewhere.

Of course you can always get your initial data from my newsletter, the Defensive Value Report, which gives high level data such as PE10, G10 and yield (all of which I’ll cover in upcoming posts) for all FTSE 350 companies.

Okay, so let’s get into the details…

How to measure revenue growth

The simplest way to look at 10 year growth is to just compare the revenue per share figure from the latest annual report with the one from 10 years ago.

I’ve tried various combinations to find the most accurate and robust measure of long-term growth.  I’ve tried looking at the average of the growth from each individual year, or combining 10, 5 and 3 year growth rates, but after much experimentation it seems that a simple 10 year growth figure is as good as anything else for highlighting long-term growth companies.

One caveat with revenue is that some companies don’t have revenue numbers.  Depending on where you get your data you may not see revenue for banks, insurance companies and various other types of businesses.  In these cases you’ll just have to look through the annual reports to work out what the equivalent of revenue is.  For example, with insurance companies I use net written premium.

How to measure earnings growth

For earnings I prefer to look at adjusted earnings.  The reason for this is that I’m looking to measure growth over time, so I need a reasonably smooth and less volatile number to measure, and adjusted earnings tend to be less volatile than basic earnings.

With basic earnings, even in very stable businesses you can have big changes in a single year, or even losses which will mess up any long-term growth calculation.  For example, if the loss doesn’t impact the company’s long-term earnings power.

Earnings power is a term that I like because it conveys the idea of a company’s ability to earn money, not just the actual amount that it earns in any one year.

If you look at BP for example, then the last 10 years basic earnings look like this:

So in 2010 there was a big loss in basic earnings.  If we were to take the 10 year growth figure in 2010 we’d have a negative 10 year growth number for that period, which would be hugely misleading.

This is less of a problem for revenues because that’s a more stable number and is never negative.  With dividends the problem does exist, but to a lesser extent because dividends are typically more stable than earnings.

By looking at adjusted earnings instead of basic earnings we can get a clearer picture of what the company is actually doing, and how the earnings power may be changing through the years.

But we can go a step further.  Ben Graham came up with a scheme for reducing the volatility of earnings even more, giving perhaps an even better picture of how the company’s earnings power is changing.

Graham simply took the latest 3 year average of earnings and compared that with the 3 year average from 10 years ago.

To get the 3 year average from 10 years ago you’d need the data going back 13 years (as the earlier average would be from years 13, 12 and 11).  If you only have access to 10 year data then you can just use the same system but just using the earliest 3 years that you have, which actually gives the 7 year growth rate between the two 3 year averages.

In the BP example above, we’d compare the average of 15.64, 22.88 and 36.48 (which is 25) to the average of 45.49, 77.48 and 79.04 (which is 67.34).

The growth over that period is 169%, according to my spreadsheet.

And talking of spreadsheets, if you want to know the annualised growth rate over that period you can just use the rate function in excel, which would look like this:

=RATE(7,,-100,269)

Where 7 is the number of years, -100 is the ‘present value’, and 269 is the future value (i.e. 100 plus the 169% increase).

The answer is that the 3 year earnings power of PB grew by an annualised rate of 15.2% per year in that 7 year period.

How to measure dividend growth

Like revenues, dividends are generally more stable than earnings, especially with the kind of large, market leading, relatively defensive companies that I’m interested in.

For that reason I generally just use the 10 year growth rate in the same was that I do for revenue.

However, I’m always experimenting with different ways of measuring past performance.  I want the most accurate and robust methods for finding companies that can grow quickly and consistently over many years.

That may mean that at some point I might change my dividend growth measure, and if it does it’s likely to change to the same approach that Ben Graham suggested for earnings.

Putting it all together

I call my growth metric G10, because otherwise it’s a massive mouthful to say that it’s the average of the 10 year growth of revenues, adjusted earnings and dividends, where the adjusted earnings growth is calculated as the growth between the latest 3 year average and the 3 year average from 7 years ago.

Just because this is a relatively complicated measure of growth, it doesn’t mean that it has magic powers.  It’s just as likely to throw up anomalies and rubbish companies as any other numbers based approach.

However, it’s a sensible first step towards finding companies that can grow earnings and dividends faster than the market, consistently and over long periods of time.

What it doesn’t really address is consistency.  So for consistency I have a separate metric which I’ll cover in my next post.

http://www.ukvalueinvestor.com/2012/07/the-shocking-truth-about-growth-investors.html/?utm_source=UK+Value+Investor+Weekly+Newsletter&utm_campaign=b0bc20d760-UK_Value_Investing_Weekly7_14_2012&utm_medium=email

Investment Objectives

Evaluation of Customers - Investment Objectives

This section refers to general investment objectives, not the client's specific needs such as retirement at a certain age or college plans for his/her children (see the next section on capital needs). However, there is certainly a correlation between the two, and it is useful to know the characteristics of each of these investment goals:

• Preservation of capital - the investor is more concerned with safety than return. Treasury bills and money market funds may be most appropriate.
  
• Current income- the investor needs a portfolio that produces steady income for current living expenses. Bonds, annuities, and stocks with high dividends (such as utility stocks) may be appropriate.
  
• Tax-exempt income -
  
• Growth and income - the investor is looking for a portfolio that generates some amount of income, but he/she is looking for capital appreciation as well (often for protection against inflation). Appropriate investments could include a mix of bonds and stocks.
  
• Capital appreciation - the investor's goal is likely retirement or another event in the future, where growth is required and current income is not needed. A diversified stock or mutual fund portfolio is appropriate.
  
• Aggressive growth - the investor is looking for high-risk investments with a potential for very large returns. This is rarely the goal for an entire portfolio, but rather for a specific portion of assets. Aggressive growth funds and small-cap issues may be most appropriate.

Read more: http://www.investopedia.com/exam-guide/finra-series-6/evaluation-customers/investment-objectives.asp#ixzz1yhxwhzOn

The Reasons You Should Invest in Quality Growth Companies for the Long Term

The reasons you should review your philosophy and strategy in stock investing:

1.  You can create wealth only by adding value to resources or by providing a service of value.
2.  Only investments in active businesses are capable of adding value.
3.  Owning a business, though very rewarding, is expensive and risky; but owning shares in a variety of successful businesses eliminates most of the risk while retaining most of the reward.
4.  Buying the stock of quality growth companies and holding it for the long term provides substantial, predictable returns.
5.  Short term trading (BFS/STS) is unpredictable and stacks the odds against you, because it relies upon winning at some loser's expense and because there's no assurance that you won't be the loser.
6.  The benefits of long-term investing include carefree portfolio maintenance, the potential to double your money every five years, the deferment of taxes, and the fact that there are rarely any losers.



Let's review the simple mathematics that makes this method work:

1.  Assume that 15 times earnings is a fair multiple for a good company and that the company earned a dollar per share last year.
2.  You will therefore pay $15 for the stock.
3.  In five years, the earnings will have grown to $2 per share.
4.  At 15 times earnings, the price will then be $30.

The value of your investment will have doubled - in five years!


Hopefully you're satisfied with the logic behind this investing approach and can see its advantages.  

Let's dispel any doubts you might have about whether you can be successful.



The best way to minimize the risk is to invest in good quality companies for the long-term, expecting not to make a killing but to earn as much as good quality companies are capable of earning for their shareholders.

Focus on Investing in Growth Companies for the Long Term

Since the early 1940s, when World War II brought the Depression to an end, there has never been a long-term catastrophe in the stock market.  Even in the worst of times, good companies continue to earn, and many stocks buck the trend.  To be sure, some of the weaker companies with poor management fold, but the well-managed, strong companies quickly scoop up their market share and life goes on.

Focus on investing in growth companies for the long term and , if the time arises when you need to take cash out of your account, sell off portions of your losers - the ones whose sales and profit growth is sluggish, not necessarily the ones whose prices are down.

This will assure you that when the market comes back up, which it surely will, you'll have a portfolio of winners.  Have faith that the companies you own a piece of will perform well in the long term and so, therefore, will your investments.  (And gloat as you continue to rack up 15-percent years while your contemporaries are pulling down 6 percent and paying the taxes on it every month.)

Warren Buffett interview on how he loves to do business

Listen to Warren Buffett's view on growth companies.

Who is a Value Investor?

Morningstar is a widely used source of mutual fund information, and it categorized 38 percent of mutual funds as value funds in 2001. But how did it make this categorization? While it did look at the way these funds described themselves in their prospectus, the ultimate categorization was based on a far simpler measure. Any fund that invested in stocks with low price-to-book value ratios or low price earnings ratios, relative to the market, was categorized as a value fund. This categorization is fairly conventional, but we believe that it is too narrow a definition and misses the essence of value investing.

Another widely used definition of value investors suggests that they are investors interested in buying stocks for less than what they are worth. But that is too broad a definition, because you could potentially categorize most active investors as value investors on this basis. After all, growth investors (who are often viewed as competing with value investors) also want to buy stocks for less than what they are worth.

So, what is the essence of value investing? To understand value investing, we have to begin with the proposition that the value of a firm is derived from two sources—

1. investments that the firm has already made (assets in place) and 
2. expected future investments (growth opportunities). 

What sets value investors apart is their desire to buy firms for less than what their assets-in-place are worth. Consequently, value investors tend to be leery of large premiums paid by markets for growth opportunities and try to find their best bargains in more mature companies that are out of favor. 

Even with this definition of value investing, there are three distinct strands that we see in value investing. 

1. The first and perhaps simplest form of value investing is passive screening, where companies are put through a number of investment screens—for example, low PE ratios, marketability, and low risk—and those that pass the screens are categorized as good investments. 
2. In its second form, you have contrarian value investing, where you buy assets that are viewed as untouchable by other investors because of poor past performance or bad news about them. 
3. In its third form, you become an activist value investor who buys equity in undervalued or poorly managed companies but then uses the power of your position (which has to be a significant one) to push for change that will unlock this value.

http://media.wiley.com/product_data/excerpt/32/04713450/0471345032.pdf

The History and Rebirth of Growth Stocks Investing.

By BetterInvesting On April 5, 2012 ·

The editorial of the January issue of BetterInvesting Magazine features a letter from Ted Brooks of North Carolina, who provides a brief history of growth stock investing and the important role BetterInvesting co-founder George Nicholson played in popularizing this investing philosophy. In 1940, when Nicholson was just beginning his “bold experiment” of helping individual investors form investment clubs to pool resources and analyze stocks, growth stock investing was no longer in vogue, replaced by Benjamin Graham’s value approach in light of the 1929 crash.

January 2012 vol 61, No. 5 BetterInvesting Magazine

Reader’s Letter Provides Context for the SSG (The Stock Selection Guide)
In investing circles we tend to take some ideas for granted. In August 2005 we published an article discussing the history of growth stock investing. But a recent letter from reader Ted Brooks of North Carolina, spurred by our article on Better¬Investing’s 60th anniversary in the November issue, provides an excellent history lesson. Below is his letter, edited for Associated Press style and length.

When the Dow Jones industrial average was introduced on May 26, 1896, the world of common stocks was beginning to evolve into three distinct categories: railroads, public utilities and “industrials” (everything else). It is important to note that the “industrial” common stocks were not considered an appropriate investment vehicle for the prudent investor at that time; such investors would limit their holdings to bonds, preferred stock and perhaps an occasional railroad or public utility common stock. This attitude prevailed until around World War I.

While eschewing common stock for bonds and preferred stock sounds strange to our ears, it was not without justification. The DJIA started off as an arithmetic average of the stocks’ closing prices. In other words, the average price of stocks in the DJIA initially bounced between about $40 and $80 and did not break $100 until 1906. What few people realize is that prior to 1915, common stock prices were quoted as a percentage of par value (like bonds and preferreds), and par value was typically $100. If these sound like “junk bond” prices to you — you’re right!

During this period, value investing — focusing on dividend yields, low P/E and discount to book value — prevailed. These concepts carried over readily from the realm of bond and preferred stock analysis.

The man generally credited with introducing the concept of growth stock investing is Edgar Lawrence Smith. Smith’s book, Common Stocks as Long Term Investments, stated that common stocks had a history of outperforming bonds under all economic conditions, going back at least to the end of the Civil War. Now, in early 1925, both the book’s title and theme were outrageous statements that flew in the face of all prevailing logic — something present-day investors do not fully appreciate. Unfortunately, Smith’s book and ideas would see a meteoric rise and fall. …In the first edition of Security Analysis (c. 1934), Benjamin Graham wrote a harsh criticism of Smith and his “growth stock” ¬disciples, and he urged investors to go back to the old rules of valuation that were discarded as obsolete during the bubble (leading to the 1929 crash).…

Against this backdrop, it is easier to understand George Nicholson’s courage in proposing the idea of investment clubs in 1940. Individual investors analyzing stocks? Buying growth stocks? George, where have you been for the last decade — living under a rock?

The BetterInvesting principles of demanding consistent growth in sales and earnings over a period of five-10 years, stable or increasing profit margins and closely watching valuations did not come out of thin air. They all came out of the hard lessons learned in the late 1920s when they were disregarded (as they were during the tech and dot-com bubble of the late 1990s). Nicholson recognized that focusing on these aspects — together with a graphical representation known as the SSG — allowed new investors to gain experience without wading into the trickier aspects of differentiating between a “value play” and a “value trap.” Nicholson’s “bold experiment” required a leader possessing both courage and clear thinking to make it reality in that historical context. I think all of these things combine to make Nicholson’s legacy what it is.

http://blog.betterinvesting.org/investing/the-rebirth-of-growth-stocks/

How to Pick Your Investment Style

Warren Buffett's approach to Growth. Growth on its own is not a valuable thing as a rule.

Benjamin Graham's approach.

Look first at Assets.
Then look at Earnings Power - making sure that they are protected by the assets.


Warren Buffett's approach.


Look at Assets and Earnings Power.
Only then, look to pay something for Growth.
Growth is only valuable if the return on investment in growth is greater than the cost of capital.
If not, growth can destroy value.
Growth on its own is not a valuable thing as a rule.
If you are going to buy growth, you better be sure of the franchise value.

Investors In Common Stocks Must Get Valuation Right; Here’s How

By Chuck Carnevale

Mar 09, 2012 04:54AM GMT

Chuck Carnevale

 

The investment industry is replete with pundits and self-proclaimed experts espousing various principles and rules that allegedly are the best way to value a stock correctly. Unfortunately, and in most cases, these rules are stated as fact, but unfortunately very few facts are ever presented to back them up.  In other words, much of it is either opinion or gleaned from something they’ve read or been taught before.  But even as a young boy, I was never willing to accept dogma as fact without simultaneously being provided supporting evidence and a logical explanation as to the “why” that they work.

In fifth grade I was once sent to the principal’s office by my English teacher because I made her cry.  She cried because every time she would regurgitate a rule of grammar, punctuation or spelling, she expected me to accept it unconditionally, merely because she said so.  For example, she would say something like I before E except after C expecting me to simply accept this rule as fact. I, on the other hand, not meaning to be argumentative or disruptive, only inquisitive, would immediately raise my hand in class and ask a simple question-why? No matter what rule she would state, I would relentlessly raise my hand and ask okay, but why?  I was not willing to have the rule dictated to me; I needed to understand why it was the rule and why it was important.

Now that I am an adult, I have continued to embrace my inquisitive nature, and to this day I will not accept a dogmatic statement without understanding why.  On the other hand, when I can review supporting evidence that validates the rule and therefore understand its significance, relevance and validity, then and only then, through my understanding it, can I embrace it willingly and passionately.  Therefore, as an author of financial articles, I believe my readers should hold me to this same standard that I hold others to.  Consequently, this article is designed to illuminate the “why” behind widely accepted notions of valuing a business primarily based on earnings (discounting cash flows).

When Investing in a Business Earnings Determine Intrinsic Value

In his best-selling book One Up On Wall Street, famed portfolio manager Peter Lynch dedicated his entire 10th chapter to earnings and thus titled it –Earnings, Earnings, Earnings. In the chapter’s second paragraph he succinctly stated the importance of earnings as follows:

“There are many theories, but to me, it always comes down to earnings and assets.  Especially earnings.  Sometimes it takes years for the stock price to catch up to a company’s value, and the down periods last so long that investors begin to doubt that it will ever happen. But value always wins out-or at least in enough cases that it’s worthwhile to believe it.”

An important foundational principle behind this discussion is the idea that we are talking about investing as part owners of strong businesses, rather than trading stocks.  Business owners are rewarded through the profits the companies they own are capable of generating on their behalf. These rewards can come in the form of salaries and bonuses for active owners, and from increasing value or cash flow from dividends for passive shareholders. In either event, all these rewards are ultimately a function of the businesses’ earnings capability, at least in the longer run.  Therefore, we should realize that when you truly invest in a stock, you really are investing in its ability to earn more money for you in the future.

When I first read Peter Lynch’s famous book in 1990, I had already developed a strong belief in the importance of earnings regarding assessing the fair value of an operating business.  Therefore, the theory behind Peter Lynch’s wisdom already resonated deep within me.  However, as already stated, it was the facts behind the theory that interested me the most. In fact, I was so committed to the notion that earnings determine market price, that I developed my own stock graphing tool that allowed me to evaluate the true relationship between a company’s earnings and its stock price over time.

The following additional quotes from Chapter 10 of Peter Lynch’s book titled: Earnings, Earnings, Earnings, speak to the importance of valuing a business based on its earnings power:

“you can see the importance of earnings on any chart that has an earnings line running alongside the stock price….  On chart after chart the two lines will move in tandem, or if the stock price stays away from the earnings line, sooner or later it will come back to earnings.”

A few pages later, Peter offers us another nugget of wisdom on the earnings and price relationship, plus a little bit of investing advice thrown in:

“a quick way to tell if a stock is overpriced is to compare the price line to the earnings line……. If you bought familiar growth companies…… when the stock price fell well below the earnings line, and sold them when the stock price rose dramatically above it, the chances are you would do pretty well.”


Now that we’ve reviewed some investing axioms and nuggets from Mr. Peter Lynch, let’s see if we can perform two extremely important tasks. 

• First and most importantly, let’s see if we can answer the more important question as to why earnings determine market price; not just that it does. 
• Next, let’s produce some evidence that verifies the veracity of Mr. Peter Lynch’s words. 

In order to accomplish both of these important tasks we will rely on visual representation, and mathematical proofs provided by F.A.S.T. Graphs™. 

How to Value a Company’s Earnings and Why

The essential point underpinning the thesis of this article, is that when you’re investing in a business you’re not actually buying the stock, you’re buying the company’s earnings power.  The stock is only the vessel that contains the earnings you are purchasing.  When buying earnings, the principles of value apply just like they do with any other product or service. The easiest way to understand this clearly, is to think in terms of the price you pay to buy $1 dollar’s worth of one company’s earnings versus $1 dollar’s worth of another company’s earnings.

In other words, let’s look at two companies to see what the price, and therefore, value, of $1 dollar’s worth of earnings are. However, before we do, let’s establish some doctrine that we are going to focus on. First and foremost, remember that we are going to buy $1 dollar’s worth of earnings for each of our two companies.  Now, we need to clearly understand that once either of those dollar’s worth of earnings are taken out of the business and put into our pockets, the value of each dollar’s worth of earnings is precisely the same. When separated from the business, a dollar is a dollar, and a dollar from one company will buy no more or no less than a dollar from another company.

However, we also have to deal with the fact that $1 dollar’s worth of each respective company has a different cost.  This then begs the question, why? 

• In other words, why would we pay more to buy company A’s dollar worth of earnings than we would to buy Company B’s dollar worth of earnings? 
• Since a dollar’s worth of each company’s earnings once received outside of the business is worth exactly the same, why would we pay more to buy one of the dollars than the other?

The reason, as we will develop more fully later, is that if we are long-term investors in businesses, we are actually buying future earnings, not current earnings. Therefore, the amount of earnings we accumulate in the future will be a function of the company’s earnings growth rate, and will determine what price we paid today to buy those future earnings of tomorrow. Let’s clarify this by examining the dynamics of our two example companies. We will start with history presented as evidence of what has actually already happened, and then we will move on to the future, which we believe is actually more relevant.

Our first example is Sherwin-Williams Co. (SHW), which has achieved a historical earnings growth rate of 9.6% since 1999. At the bottom of the graph you can see that earnings have grown from $1.81 per share in 1999, to an estimate of $5.67 per share for fiscal 2012 (see yellow highlighted earnings at the bottom of the graph).  This represents approximately a three-fold increase in earnings over the past 14 years. The primary point is that every $1 dollar’s worth of earnings you bought in 1999, are now worth approximately $3 dollars. Another way to put this is that Sherwin-Williams’ future dollars in 2012 only cost one third as much as the original $1 dollars worth of earnings cost in 1999.

 SHW Chart 1

Our second example, CSX Corp. (CSX), grew earnings per share at the higher rate of 12.9% since calendar year 1999.  Therefore, earnings per share grew from $.26 a share in calendar year 1999 to $1.86 per share estimated for fiscal year-end 2012 (see yellow highlighted earnings at the bottom of the graph). This is approximately a seven-fold increase in earnings per share over this 14-year period. The primary point is that every $1 dollar’s worth of earnings you bought in 1999, are now worth approximately $7 dollars. Consequently, shareholders that bought CSX in 1999 only paid 1/7th of the original price for calendar year 2012 earnings.  In other words, due to the company’s historical earnings growth rate, future earnings were significantly cheaper than original earnings. As we will discover next, herein lays the essence of fair value, or what others call intrinsic value of a business (common stock).

 CSX 1

Now let’s move to current time to examine what price we have to pay to buy $1 dollar’s worth of each of our example company’s earnings today, and attempt to calculate what $1 dollar’s worth of future earnings are actually costing us. The metric that establishes that price is the common PE ratio.  One of the definitions of the PE ratio is: The price you pay to buy $1 dollar’s worth of a company’s earnings.  Remember though, we are pricing $1 dollars worth of today’s earnings, even though in actuality what matters most is the price we’re paying to buy $1 dollars worth of future earnings.

In the case of Sherman-Williams (SHW), today we are asked to pay $20.90 (current PE ratio 20.9 see red circle at right of graph ) to buy our $1 dollar’s worth of current earnings.  As an aside, you can note from the graph that this is the highest valuation or price that you were asked to pay to buy a $1 dollar’s worth of Sherwin-Williams’ earnings since 1999.  In other words, Sherwin-Williams’ stock appears very expensive today based on historical earnings growth.

 SHW 2

In the case of our second example, CSX Corp. we discover that we are only being asked to pay $11.90 (current PE 11.9 see orange circle at right of graph) to buy $1 dollar’s worth of CSX Corp.’s current earnings. This is almost half the price we are being asked to pay to buy an equivalent $1 dollar’s worth of Sherwin-Williams Co.’s earnings. Therefore, the rational investor should ask this simple question:  Why should I be willing to pay almost twice as much to buy Sherwin-Williams’ earnings as I’m being asked to buy CSX’s earnings? The only logical answer would be because future earnings are expected to be much higher for Sherwin-Williams Co. than for CSX Corp. But in fact, this is not true, and as we will next illustrate, the real answer doesn’t make any mathematical sense.

 CSX 2

Utilizing the Estimated Earnings and Return Calculator we discover that the consensus (15 analysts reporting to Capital IQ) estimate earnings growth rate for Sherman-Williams at a very strong 13.1%. This calculates out that expected calendar year 2017 earnings of $10.64 will be approximately twice as large as 2011’s earnings of $4.95.  Therefore, we are, in theory at least, only paying approximately $10 today to buy a future $1 dollar’s worth of Sherwin-Williams’ 2017 earnings.  In other words, the PE ratio of the future earnings we are buying is approximately 10, or half of what we have to today pay for current earnings.

 SHW 3

Once again, utilizing the Estimated Earnings and Return Calculator we discover that the consensus (26 analysts reporting to Capital IQ) expect CSX Corp. to grow earnings at a very strong rate of 14%. This calculates out that CSX Corp.’s expected earnings in 2017 will also be approximately 2 times larger than today’s earnings of $3.63 in 2017 versus the original $1.67 in 2011.  To be clear, this means that the earnings growth rates in both of our sample companies are expected to be essentially the same or at least similar.

Most importantly, it also means that we are only paying a PE of 5.6 to buy CSX Corp.’s $1 dollar’s worth of future earnings (2017) versus paying a PE of 10 for Sherwin-Williams’ $1 dollar’s worth of future earnings (2017). As we’ve previously established, if we received $1 dollar’s worth of dividends from both companies, each would be able to buy no more or no less goods or services than the other.  So once again we ask the question; why would we want to pay twice as much to buy $1 dollar’s worth of Sherwin-Williams’ future earnings as we would to buy CSX Corp.’s? Logically, it makes no sense, yet many investors do it every day.

 CSX 3

In the two examples used in our analogy above, we identified two companies with somewhat similar historical growth rates, but more importantly with almost identical expectations for future growth.  Consequently, logic should dictate that both companies should be priced at approximately the same valuations.  The examples utilized, neither company has a real edge over the other company regarding earnings power. Therefore, why should the one, Sherwin-Williams Corp., have an edge in market price over the other, CSX Corp.? The straightforward answer; there is no rational reason.

It’s also important to recognize that the market does not always price common stocks according to their fair value.  In fact, at any moment in time, the market can be mispricing the value of common stocks by significant degrees.  This is why the venerable Ben Graham gave us his famous metaphor: “in the short run the market is a voting machine, but in the long run it’s a weighing machine.”  This is the same lesson that Peter Lynch offered in the above referenced quote where he talks about value eventually winning out.  Shrewd investors know how to calculate fair value, and therefore, are capable of avoiding what is often the obvious mistake of paying too much.  On the other hand, shrewd investors also recognize a bargain when they see one.
Furthermore, it should also be understood that there are valid reasons to pay more for one company than for another.  However, those reasons have to be mathematically sound and, therefore, make economic and prudent sense.  For example, thanks to the power of compounding; a company with a very high growth rate of 20% to 30% or more would obviously be worth more than a company only growing at 10% or 15%.

• The point is that the faster growing company would be capable of generating significantly more future earnings than the slower growing one.  
• Therefore, even though you pay more today to buy the faster grower, you can actually be buying future earnings cheaper, again, thanks to the power of compounding.

Summary and Conclusions

The moral of the story is simply that investors should be careful and willing to always run the numbers out to their logical conclusions. But, it all starts with knowing what you are buying (investing in) in the first place.  True investors, like Peter Lynch, and many of the other renowned investing greats such as Phil Fischer, Warren Buffett, etc., all invest as owners in businesses with a focus on the strength of the business behind the stocks they buy. Therefore, these investor greats are always buying the earnings power of the respective businesses they are investing in, relative to their goals and objectives.

These principles of valuation apply equally to growth stocks as they do dividend stocks.  When applied to growth stocks,

• investors need to understand that the more future earnings they can buy today at a good price, means more future earnings that the market can capitalize in the future.  
• Since this is their only source of return, the more future earnings they can amass the more value or return they can expect.  
• Fast growth does typically come at a higher price, but simultaneously it needs be understood that faster growth, if it occurs, also generates a bigger pile of future earnings. 
• And, as this article has illustrated, it’s the future earnings that ultimately drive fair value.

When applied to dividend paying stocks, the principle is just as valid, and maybe easier to see.  

• Since the company is going to pay dividends, the dividend investor is going to receive some of the company’s earnings in cash outside of the business.  
• As I illustrated above, when they go to spend $1 dollar’s worth of dividends from Company A versus $1 dollar’s worth of dividends from Company B, each $1 dollar’s worth of dividends will have the same value outside of the business.  
• Therefore, it only logically follows that both of those dollars should have the same value while they are still in the business.

Importantly, a few words on the differences between investing and speculating are perhaps in order. 

Active traders will not find any value in this discussion, because

• active traders usually don’t own a company long enough to think about earnings power at all.  
• Active traders are only really interested in momentum and volatility.  
• They are “the voting machine” segment of the market. 
• This is a primary reason why stocks can become improperly or unrealistically valued by Mr. Market, the voter; however, there are others reasons that we will leave to future discussions. 
• Additionally, to be a trader requires a continuous commitment to watching every little price tick of the market, which is beyond the interest of most people that are investing for their future economic benefit.

True investors are interested in 

• building long-term positions in great businesses bought at rational prices. 
• It is to this segment of the financial community that this article is geared to. 
• Frankly, we believe this is the largest segment of the market comprised of prudent investors that have other things to do with their time than watching the bouncing ball of often frivolous stock price movements.  
• These true investors need to understand the principles of valuation presented in this article if they are going to achieve their financial goals while simultaneously doing so at reasonable levels of risk.

Based on this discussion, of the two companies utilized as examples in this article, the principles of valuation would indicate that one is a buy and one is a sell. We believe that both of these companies are excellent candidates that when appropriately priced (valued) would make great additions to almost any long-term investors portfolio.  However, if the expected future growth rates are accurate, then Sherwin-Williams is clearly overpriced, while CSX Corp. looks like a great bargain today.  Of course, all prospective investors are encouraged to perform their own due diligence before taking any action.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

http://www.forexpros.com/analysis/investors-in-common-stocks-must-get-valuation-right;-here%E2%80%99s-how-116410

Benjamin Graham and The Power of Growth Stocks

Benjamin Graham and the Power of Growth Stocks: Lost Growth Stock Strategies from the Father of Value Investing

by Frederick K. Martin CFA & Nick Hansen

Use a master's lost secret to pick growth companies bound for success In 1948, legendary Columbia University professor Benjamin Graham bought a major stake in the Government Employees Insurance Corporation. In a time when no one trusted the stock market, he championed value investing and helped introduce the world to intrinsic value. He had a powerful valuation formula. Now, in this groundbreaking book, long-term investing expert Fred Martin shows you how to use value-investing principles to analyze and pick winning growth-stock companies—just like Graham did when he acquired GEICO. Benjamin Graham and the Power of Growth Stocks is an advanced, hands-on guide for investors and executives who want to find the best growth stocks, develop a solid portfolio strategy, and execute trades for maximum profitability and limited risk. Through conversational explanations, real-world case studies, and pragmatic formulas, it shows you step-by-step how this enlightened trading philosophy is successful. The secret lies in Graham's valuation formula, which has been out of print since 1962—until now. By calculating the proper data, you can gain clarity of focus on an investment by putting on blinders to variables that are alluring but irrelevant. This one-stop guide to growing wealth shows you how to: Liberate your money from the needs of mutual funds and brokers Build a reasonable seven-year forecast for every company considered for your portfolio Estimate a company's future value in four easy steps Ensure long-term profits with an unblinking buy-and-hold strategy This complete guide shows you why Graham's game-changing formula works and how to use it to build a profitable portfolio. Additionally, you learn tips and proven techniques for unlocking the formula's full potential with disciplined research and emotional control to stick by your decisions through long periods of inactive trading. But even if your trading approach includes profiting from short-term volatility, you can still benefit from the valuation formula and process inside by using them to gain an advantageous perspective on stock prices. Find the companies that will grow you a fortune with Benjamin Graham and the Power of Growth Stocks.

http://www.lybrary.com/benjamin-graham-and-the-power-of-growth-stocks-lost-growth-stock-strategies-from-the-father-of-value-investing-p-125191.html