The Growth Conundrum

As a long term investor, one should be concerned with two things while buying a stock,

• Quality of the Business
• Price at which one buys the stock

Courtesy of internet, screens, forums, list of bloggers on this blog the the chances of you coming across good businesses and stock ideas is pretty high (serendipity). So without much effort the first point is taken care of.

It is on the second point that divergence appear amongst investors, and it appears more so in case when we are talking of stocks on high growth path.

For last few days I have been struggling to solve this problem of "what price to pay for growth" until i bumped onto one of the blogs of Aswath Damodaran ( If anyone wants to learn valuation, please go through his lectures. They are free and brilliant). The link to these blogs are here and here

Based on the blog I ran the test on 5 companies, who meet probably all criteria of a quality business. These were: Amara Raja, Astral Poly, Atul Auto, GRP and Kaveri Seeds.

Before, jumping to conclusions of the test let me first share the methodology here.

Step: 1 : Find out the enterprise value of the stock ( Mcap+Debt- Cash)
Step: 2:  If we assume that company doesn't do any growth going forward then it can pay the entire income out to stockholders as dividends and as interest to lenders.In this case, operating income from the most recent period will be cash flow each year in perpetuity. The value of these cash flows can be computed by discounting back at a cost of capital to yield a value for assets in place.By doing this we know what is the value of assets which company holds now.
Step 3: This involves calculating the value of assets which are required for growth. To calculate this we would need the following inputs

• Expected growth rate: I have assumed 25% for all the 5 companies
• Expected Return on Capital: I have taken average last 5 years as an indicator for this.
• Length of Growth: I have assumed 5 years,since all of them operate and have strengths to deliver growth for long periods.
• Reinvestment Rate: For a company to grow it needs to reinvest money it earns into business which can be calculated as Reinvestment Rate= Expected growth rate/RoC

Once we have this data in place we simply to a DCF for 5 years, with operating income of each year being reduced by the reinvestment amount required.

Step 4: The difference between EV(Step 1) and Value of Assets( Step 2) gives us the price which we are paying for growth.
Step 5: Comparing price found in step 4 with value of assets for growth( Step 3) will give us an indication whether this stock is overpriced/cheap/fairly valued.

The results of my analysis courtesy Prof. Damodaran are given below. Also attached is the link for excel sheet with all calculations. It is a modified version of what Prof. has shared on his blog. 
 

Inputs	Amara Raja	Astral	Atul Auto	GRP	Kaveri
Growth Rate	25.00%	25.00%	25.00%	25.00%	25.00%
RoC ( Avg. 5 years)	31.00%	21.80%	30.00%*	29.40%	20.00%
Growth Period	5	5	5	5	5
Cost of Capital	15.00%	15.00%	15.00%	15.00%	15.00%
Stock Price	239	310	114	1603	1073.00
Outputs ( In Crs)
Enterprise Value	3918	727	121	269	1361
Value of Assets in Place	1442	322	107	159	427
Value of Assets for Growth	1107	149	80	116	159
Price Paid for Growth	2476	405	13	111	934
Price Paid/Value	2.24	2.71	0.17	0.96	5.89

* For Atul Auto RoC is average of last 3 years.

The link for the excel sheet is here. One can modify all the input parameters into the sheet to see at what price/growth rate/RoC does a stock become overvalued or cheap.




Has this solved my conundrum? Yes, but i have fallen into another conundrum of a few biases :(. More on that later

Till then Happy "growth" Investing.

Regards,
Saurabh
PS- Invested in Atul Auto, GRP & Kaveri Seeds, although all are very small positions as of now.