Value, Growth & Intrinsic Investing Revisited
“Growth and value are part of the same equation. Or rather growth is part of the value equation.” -Warren Buffett
In our first post on this blog in 2015, we wrote:
“The world of investing is traditionally divided into growth and value approaches. Growth investors favor buying stocks of companies that are growing quickly while value investors buy stocks that they believe are cheap. But this is a false dichotomy. All else equal, fast growing companies are more valuable than slow growing companies and so any sensible approach to investing will recognize that growth is a component of value, not the opposite of value.”
Today, we want to elaborate on the roles of growth and value in investing and explain how the growth vs value divide in the investment industry is based on a mistaken understanding of the value equation. A growth investor may put an emphasis on buying companies with high forecasted growth rates, while a value investor may put an emphasis on buying stocks with high current cash flow yields, but in both cases, it is the combination of cash flow yield and the growth in cash flow that drives investment returns.
Let’s start with how equity returns are generated. A simple model is to think of a stock like a bond. Start with the distributable cash flow yield, just as you would with a bond coupon. We can call that “Y” (for yield). Unlike most bonds, which have a contractually fixed cash payment, stocks have no fixed cash flows, and those cash flows can grow or shrink in any given year and over time.
Since the economy grows, the companies which make up the stock market will also see their earnings grow in aggregate. That growth (which we will call “G”) over time contributes to the return an investor will earn. So, while bonds will pay out their returns to investors in the form of fixed coupons, equity investors have a portion of their return tied to the growth of the company.
To demonstrate that this is true, we can use the Gordon Growth Model, an elegant and simple way to establish the value of a series of cash flows. It is important to note that the Gordon Growth Model assumes a constant, perpetual rate of growth*.
The Gordon Growth Model is as simple as it gets. It can be rearranged in various ways, but for our purposes we’ll use this formulation:
Y + G = Rate of Return
Y = Starting distributable cash flow yield
G = Growth rate of distributable cash flow
Distributable cash, or the cash flow left after funding any capital requirements needed to grow and reserving the cash needed to cover the eventual cash cost of non-cash expenses (such as stock based compensation), can be returned to shareholders via a dividend or share buybacks, used to pay down debt, or used to acquire other companies. For our purposes we’ll assume it is paid out as a dividend, but if the cash is used for the other purposes, the result is the same so long as the money earns its cost of capital (no less and no more).
As an example, let’s say you have a company that trades with a valuation in the stock market such that it has a distributable cash flow yield (Y) of 4%. And let’s say that the company is expected to grow (G) at 5% in perpetuity. Then the Gordon Growth Model says:
Y + G = Rate of Return
4% + 5% = 9%
9% is the historical long term return to equities, 4% has been the average distributable cash flow yield of the S&P 500 over the long term, and 5% has been the long term rate of growth for S&P 500 cash flows. So, while the Gordon Growth Model is a relatively simplistic model, it also accurately captures the way the US stock market has been valued over the long term.
But there are other ways to solve for this same 9%. Let’s consider two example investments, Growth Company and Value Company, which we will assume have the same level of risk of generating their forecasted level of growth.
Growth Company will grow at a 7% rate. So, what is a fair price for its stock? We can easily solve for the required cash flow yield to earn 9% by subtracting the 7% growth rate to get 2%. In other words, Growth Company deserves twice as high of a valuation (ie. half the cash flow yield) as the S&P 500.
Value Company will grow at a 1% rate. We can use the same process above to calculate that the stock of Value Company must offer an 8% cash flow yield for the stock to earn 9%. In other words, the stock of Value Company is fairly valued at half the valuation of the S&P 500, and just one quarter the valuation of Growth Company.
If you invert the cash flow yields you get these distributable cash flow multiples** as the fair value for each investment.
Growth Company 50x
S&P 500 25x
Value Company 12.5x
Many investors would look at the valuations above and conclude that Value Company is “cheaper” than the S&P 500 and much cheaper than Growth Company. But Warren Buffett rejects this line of thinking.
All three investments offer the same 9% rate of return. Value Company earns that 9% through a high Y and just a little G. While Growth Company earns 9% through a high G and a low starting Y. But they both offer the same rate of return and so they are valued equally to each other.
The Gordon Growth model makes clear that both the price you pay relative to current distributable cash flow and the growth of that cash flow are components of the value equation. In the opening quote to this post, Buffett explains the same thing in two different ways to make sure the listener gets it:
“Growth and value are part of the same equation.” Or in other words; Y and G are both part of the equation that drives investors’ returns.
“Or rather growth is part of the value equation.” In other words, Y is NOT value. Both Y and G combine to define value.
It is this second, nuanced clarification that Buffett makes that the investment community often doesn’t quite seem to appreciate. When most investors discuss a value stock or a value investing approach, what they mean is that the stock has a high Y or the investment approach invests in companies with high Ys. But this is a serious mistake that flies in the face of the teachings of Warren Buffett, an investor who has done more than anyone to popularize and explain value investing.
You can hear directly from Warren Buffett on this topic at the 2001 Berkshire Hathaway annual meeting.
A high Y just means that an investor is paying a low price relative to current cash flow. While this means the cash flow does not need to grow as fast in order to earn an acceptable rate of return, it does not mean that the stock is trading at a discount to its fair value. As Buffet points out, growth is also part of the value equation and so no observation about whether a stock is trading at a low valuation can be based only on Y, it must also include an analysis of G.
In order to beat the market with a long term investment strategy, investors must seek out investment opportunities where Y + G = a rate of return that is higher than the S&P 500. If you assume the historical 9% rate of return of the S&P 500 is what it will return in the years ahead, then you need Y + G = more than 9%.
It is stocks that offer 10%, 12%, 14%, 16% or higher rates of return that are best understood as being “cheap.” This can indeed be accomplished by buying stocks that trade at very low multiples of current cash flow. This is what might be called a “deep” or “classic” value approach. It can also be accomplished by buying stocks that trade at much higher multiples of current cash flow, so long as they are able to grow their cash flow at high rates for a long time.
At Ensemble, we don’t think that investors are served well by focusing on stocks with high Ys or high Gs, but rather focusing on stocks that offer high rates of return. We refer to this as intrinsic investing because in the minds of many people “value investing” means buying stocks with high Ys. But real value investing is about buying stocks for less than they are worth, which means stocks that offer forward rates of return that are higher than average. Doing this means buying stocks where Y + G = a rate of return that is above average.
In our portfolio, we own stocks like the home builder NVR, that trades at what we estimate is a current distributable cash yield of about 8% and offers growth potential over the long term in excess of the 1% needed to generate a 9% rate of return.
And we own stocks like Chipotle, which trades at what we estimate is a current distributable cash yield of about 2.5%, but we think the company is very likely to generate growth over the long term that is higher than the 6.5% rate that is needed to drive market beating rates of return.
In our view, the rate of return of Chipotle’s Y + G is likely to be higher over time than that offered by NVR’s Y + G. It is true that NVR trades at a much lower multiple of distributable cash flow than Chipotle does. And therefore, NVR needs to grow much less than Chipotle in order to generate a sufficient rate of return. But if indeed Chipotle offers a higher combination of Y + G, and thus a higher expected rate of return than NVR does, it is Chipotle that is the “cheaper” stock.
The goal of a stock picker is to select stocks that are likely to perform well on an absolute and relative basis. Some investors may find that the best path for them to do so is to search for stocks that offer a high Y. Others may believe that the best path for them is to find companies that offer high and durable rates of growth. But in the end, what matters is the rate of return a stock produces, and the inescapable math that gives rise to a given rate of return is the cash yield and growth rate combined.
In our next post on this topic, we’ll write about the importance of investors matching the time horizon of their investment to whether the investment is based more on a high Y or a high G. And we’ll argue that classic or deep value investing is inconsistent with long term investment approaches.
*Because the Gordon Growth Model is based on an assumption of a perpetual rate of growth, it is only practically applicable to mature businesses. A company cannot grow perpetually at rates faster than the economy or the company would eventually become bigger than the entire economy. In our next post, we’ll be using a two stage growth model to dig more deeply into valuing higher growth companies.
**The 25x distributable cash flow multiple noted for the S&P 500 is equivalent to a PE ratio in the 15x-18x range depending on the historical time period in question. You can read more about the relationship between PE ratios, growth rates, returns on capital, and cash yields in this post and this post.
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