The Feud Between Growth and Value
And why it’s pointless.
The investing field is divided into two opposing groups – value investors and growth investors. Value investors view growth investors as speculators, people who bet on the intangible dreams of companies. Growth investors scorn value investors as those stuck in the old times, buying boring low PER, PBR stocks with no future prospects. This article, however, will show that these two classes of investors are not that far apart – they might be talking about the same thing.
So to start, let’s talk about value… What even is value?
*This is going to involve some slightly difficult concepts. However, they are important for anyone serious about investing. So if you are one of those people, hold on.
Unlike other aspects of investing, this concept has a clear answer. The value (more accurately present value) of an asset is the discounted value of all future cash flows. This is an important point, so let me repeat it.
The present value of an asset is the discounted value of all future cash flows the asset will produce.
This idea applies not only to stock valuations but also to other cash-producing assets like bonds, farms, and real estate.
When this concept is written as an equation, it looks like this:
‘PV’ denotes Present Value. C1, C2, and C3 are the cash flows you will receive in one, two, and three years. If you buy a 3-year bond, C1 and C2 will be the interest payments after years one and two, and C3 will be the interest payment plus the principal at year three. The other variable, ‘r’ denotes the discount rate. A dollar today is worth more than a dollar next year. The discount rate determines exactly how much more the dollar next year is worth. If the discount rate is 10%, then one dollar today is equivalent to 1.1 dollars next year and 1.21 dollars next, next year ($1 x 1.10 x 1.10). ‘...’ represents the cash flows after the predictable period. If we are talking about a three-year bond, ‘...’ is 0. If we are talking about a company that is expected to operate after three years, then the cash flows it will produce will have some value. ‘...’ is referred to as CV (Continuing Value) or TV (Terminal Value).
Still a little confused? Why not another example? The classic lemonade stand.
Jaime just started a lemonade stand. At the end of year one, his earnings after all expenses is 100 dollars. The business has a growth rate of 20%, so his earnings are 120 dollars, and 144 dollars at the end of years two and three respectively. At the end of year three, Jaime decides to sell all the equipment for 50 dollars.
Using a discount rate (r) of 10%, try writing out the equation to calculate the PV of Jaime’s lemonade stand. It’s okay to get it wrong the first time.
*The discount rate is an arbitrary number. In theory, there is a model to calculate it called the Capital Asset Pricing Model, but it does not work well in practice. When Warren Buffett was asked about what discount rate he uses, he simply replied that he uses the US 10-year treasury rate.
Here’s the answer. We discount each year’s earnings depending on the year we receive those earnings. Ex. (1 + 0.1) at the end of the first year and (1 + 0.1)2 at the end of the second year. In addition, since Jaime will be selling his equipment three years later at 50 dollars, we also discount the 50 dollars at the appropriate rate (1 + 0.1)3.
Did you notice anything interesting about how we calculated value?
Well, there are many interesting factors, but the glaring one for me is that the growth rate was one of the most important components in determining value. We used a growth rate of 20% here, but it could have been any other number depending on how fast our little company will grow.
Suppose we now have two lemonade stands. One grows at 20% a year for 10 years and the other grows at 7% a year for 10 years.
Notice the stark difference in value. While the value of the lemonade stand that grows at 20% is around 1406.5 dollars, the value of the lemonade stand that grows at 7% is only worth 824.5 dollars.
So here’s the key takeaway: Growth and value are not opposing concepts. In fact, growth is a key component of value.
The converse of a value stock is not a growth stock, it’s an overvalued stock. The converse of a growth stock is not a value stock, it’s a slow-grower or non-grower.
The argument between growth and value is pointless. The more important choice lies between value today and value tomorrow. For instance, with how much certainty can we forecast the growth of a company?
Investors who believe it's difficult to know will focus on value today, such as how much cash a company holds. Those who believe they’ve found a great company that can compound for a long time will focus on the value tomorrow, such as the future cash flows the company will produce.
Phew. That was a lot. Next time, we’ll talk about a topic that involves fewer numbers – Benjamin Graham and his investment philosophy.
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