Growth as a Margin of Safety by Sui Chuan, ValueEdge
A value investor typically would not like to pay for growth. However, there are instances where the growth potential of a company has to be acknowledged. Today, we introduce Bruce Greenwald’s method of valuing growth and our interpretations of it.
The margin of safety afforded by growth can be represented by the following equation:
There are a few learning points from this. Earning Power Value (EPV) represents the value of a company under zero-growth. Usually, this is derived by discounting steady state earnings with the cost of capital (R). The insight here is that earnings can also be expressed as the product of the rate of return earned on your capital and the value of your capital. When your cost of capital (R) exceeds your return on capital, the value of your capital/firm diminishes, regardless of whether there is growth or not. This would be your typical value destroying firm.
Present Value (PV) here would be the value of a company inclusive of growth. You can observe the similarity of the formula with EPV. Contrast this with the regular DCF method, we notice that PV actually deducts for the growth rate in the numerator in addition to the denominator. The reason is that certain amount of returns each year would have to be used to sustain future growth and shareholders will have a correspondingly lower amount of earnings accrued to them. This is a new perspective not offered by the regular DCF method which neglects the cost of future growth.
The greater the amount by which the PV exceeds the current EPV, the higher the margin of safety afforded by growth. Let’s call this the growth margin of safety.
How do we use this responsibly?
We don’t want to fall into the trap of being overly optimistic on growth companies, as the majority of investors do. One advantage that this method has over traditional DCF is that it is more conservative by default – we deduct G from the numerator, resulting in a lower multiple as compared to DCF which only deducts G from the denominator. Besides this simple mechanical advantage, there are ways which we can use discretion to avoid the common pitfalls of valuing growth. First is to of course, be extremely conservative for the value of G. This is a very hackneyed advice, not exactly Nobel-prize material.
Besides our usual margin of safety (which is defined as the difference between EPV and its current price), we now have the growth margin of safety. It seems to me that the growth margin of safety alone is inconclusive in determining the degree of under/over-pricing. Therefore, the second point of discretion is a comparison of the different margins of safety. A typical over-hyped growth stock would have the following margin of safety relationship.
This is where your growth margin of safety is high but your normal margin of safety is negative by a large degree. In this case, it is a gamble on future growth occurring in an expeditious manner which in turn gives rise to the issue of expectations. I believe there are 2 scenarios where the growth margin of safety affects our investment decision.
The first is a case when your margin of safety is originally insufficiently large. However, if the growth margin of safety is significantly larger, it could warrant an investment. The difference here is that the full value of the company is not totally dependent on growth. Because there is still that margin of safety afforded by consistent, historical performance (as demonstrated by the EPV), it would be a mix between value and growth. In the Singapore market, some names come to mind which befit this description – ComfortDelgro, Vicom, Raffles Medical Group. Under the second scenario, the only difference is that margin of safety is now negative. This is more risky, however, if a small negative margin of safety is offset by an extremely high growth margin of safety (arrived under conservative assumptions), then it might still be a potentially good investment. With regards to how small is sufficiently small and how large is sufficiently large, there is unfortunately no easy answer. It is a game of probability, and value investors should demand for exceedingly good odds in this case.
If I had to choose the most important takeaway, it would be the potential benefits of discerning between a zero-growth valuation scenario and a growth valuation scenario. In fact, this is possible with the DCF method as well by simply doing one with a growth and one without growth (but keep it mind the pitfalls of DCF). Simple as it sounds, it is something that has never occurred to me and I hope it has broadened your perspectives as well.