8.1 Company Analysis Versus Stock Valuation
The common stocks of good companies are not necessarily good investments. The point is, after analyzing a company and deriving an understanding of its strengths and risks, you need to compute the intrinsic value of the firm’s stock and compare this to its market value to determine if the company’s stock should be purchased. The stock of a wonderful firm with superior management and strong performance measured by current and future sales and earnings growth can be priced so high that the intrinsic value of the stock is below its current market price (i.e., the stock is overvalued) and it should not be acquired.
In contrast, the stock of a company with lower sales and earnings growth may have a market price that is below its intrinsic value. In this case, although the company is not as good, its stock could be the better investment. The classic confusion concerns growth companies versus growth stocks. The stock of a growth company is not necessarily a growth stock! Recognition of this difference is absolutely essential for successful investing.
8.2 Growth Companies and Growth Stocks
Observers have historically defined growth companies as those that consistently experience above-average increases in sales and earnings. This definition has some limitations because many firms could qualify due to certain accounting procedures, mergers, or other external events.
In contrast, financial theorists such as Salomon (1963) and Miller and Modigliani (1961) define a growth company as a firm with the management ability and the opportunities to consistently make investments that yield rates of return greater than the firm’s required rate of return. This required rate of return is the firm’s weighted average cost of capital (WACC). As an example, a growth company might be able to acquire capital at an average cost of 10 percent and yet have the management ability and the opportunity to invest those funds at rates of return of 15 to 20 percent. As a result of these superior investment opportunities, the firm’s sales and earnings grow faster than those of similar risk firms and the overall economy. In addition, a growth company that has above-average investment opportunities should, and typically does, retain a large portion of its earnings to fund these superior investment projects (i.e., they have low or zero dividend-payout ratios).
Growth stocks are not necessarily shares in growth companies. A growth stock is a stock with a higher expected rate of return than other stocks in the market with similar risk characteristics. The stock achieves this expected superior risk-adjusted rate of return because the market has undervalued it compared to other stocks. An undervalued stock has an intrinsic value (estimated by alternative valuation models) that is greater than its current market price. Although the stock market adjusts stock prices relatively quickly and accurately to reflect new information, available information is not always perfect or complete. Therefore, imperfect or incomplete information may cause a given stock to be undervalued or overvalued at a point in time.
If the stock is undervalued, its price should eventually increase to reflect its true fundamental (intrinsic) value when the correct information becomes available. During this period of price adjustment, the stock’s realized return will exceed the required return for a stock with its risk, and during this period of adjustment, it will be a growth stock. Growth stocks are not necessarily limited to growth companies. A future growth stock can be the stock of any type of company; the stock need only be undervalued by the market.
The fact is, if investors recognize a growth company and discount its future earnings stream properly, the current market price of the growth company’s stock will reflect its future earnings stream. Those who acquire the stock of a growth company at this correct market price will receive a rate of return consistent with the risk of the stock, even when the superior earnings growth is attained. In many instances, overeager investors tend to overestimate the expected growth rate of earnings and cash flows for the growth company and, therefore, inflate the price of a growth company’s stock. Investors who pay the inflated stock price (compared to its true intrinsic value) will earn a rate of return below the risk-adjusted required rate of return, despite the fact that the growth company experiences above-average growth of sales and earnings.
8.3. Defensive Companies and Stocks
Defensive companies are those whose future earnings are likely to withstand an economic downturn. One would expect them to have relatively low business risk and not excessive financial risk. Typical examples are fast food chains or grocery stores-firms that supply basic consumer necessities. There are two closely related concepts of a defensive stock. First, a defensive stock’s rate of return is not expected to decline during an overall market decline, or decline less than the overall market. Second, an asset’s relevant risk is its covariance with the market portfolio of risky assets-that is, an asset’s systematic risk. A stock with low or negative systematic risk (a small positive or negative beta) may be considered a defensive stock because its returns are unlikely to be harmed significantly in a bear market.
8.4 Cyclical Companies and Stocks
A cyclical company’s sales and earnings will be heavily influenced by aggregate business activity. Examples would be firms in the steel, auto, or heavy machinery industries. Such companies will outperform other firms during economic expansions and seriously underperform during economic contractions. This volatile earnings pattern is typically a function of the firm’s business risk (both sales volatility and operating leverage) and can be compounded by financial risk.
A cyclical stock will experience changes in its rates of return greater than changes in overall market rates of return. In terms of the CAPM, these would be stocks that have high betas. The stock of a cyclical company, however, is not necessarily cyclical. A cyclical stock is the stock of any company that has returns that are more volatile than the overall market-that is, high-beta stocks that have high correlation with the aggregate market and greater volatility.
8.5 Speculative Companies and Stocks
A speculative company is one whose assets involve great risk but that also has a possibility of great gain. A good example of a speculative firm is one involved in oil exploration. A speculative stock possesses a high probability of low or negative rates of return and a low probability of normal or high rates of return. Specifically, a speculative stock is one that is overpriced, leading to a high probability that during the future period when the market adjusts the stock price to its true value, it will experience either low or possibly negative rates of return. Such an expectation might be the case for an excellent growth company whose stock is selling at an extremely high price/earnings ratio-that is, it is substantially overvalued.
8.6 Value versus Growth Investing
Some analysts also divide stocks into growth stocks and value stocks. As we have discussed, growth stocks are companies that will experience above-average risk-adjusted rates of return because the stocks are undervalued. If the analyst does a good job in identifying such companies, investors in these stocks will reap the benefits of seeing their stock prices rise after other investors identify their earnings growth potential. Value stocks are those that appear to be undervalued for reasons other than earnings growth potential. Value stocks are usually identified by analysts as having low price-earning or price-book value ratios. Notably, in these comparisons between growth and value stocks, the specification of a growth stock is not consistent with our preceding discussion. In these discussions, a growth stock is generally specified as a stock of a company that is experiencing rapid growth of sales and earnings (e.g., Google, Apple, and Microsoft). As a result of this company performance, the stock typically has a high P/E and price-book-value ratio.
