- July 29, 2022
- Posted by: Ramkumar
- Category: Posts
Growth Investing VS Value Investing
Investors categorise their investments into 𝐠𝐫𝐨𝐰𝐭𝐡 𝐚𝐧𝐝 𝐢𝐧𝐜𝐨𝐦𝐞 𝐬𝐭𝐨𝐜𝐤𝐬 when investing in stock markets. They invest in growth stocks because they are interested in future earnings growth rather than dividends.
So are 𝐠𝐫𝐨𝐰𝐭𝐡 𝐬𝐭𝐨𝐜𝐤𝐬 𝐝𝐢𝐟𝐟𝐞𝐫𝐞𝐧𝐭 𝐟𝐫𝐨𝐦 𝐢𝐧𝐜𝐨𝐦𝐞 𝐬𝐭𝐨𝐜𝐤𝐬?
Let us take Roblox, which develops and operates an online entertainment platform. Roblox is a classic instance of a growth company as it works in a fast-growing market and has less competition.
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐬𝐡𝐚𝐫𝐞 𝐩𝐫𝐢𝐜𝐞 𝐨𝐟 𝐑𝐨𝐛𝐥𝐨𝐱 = $𝟑𝟕.𝟎𝟒
Roblox does not pay any dividends and thus reinvests excess cash flows back to the business.
Dividend yield of Roblox = 0%
Roblox has total debt of $1.234 billion, and after paying the interest expenses, its 𝐥𝐞𝐯𝐞𝐫𝐞𝐝 𝐟𝐫𝐞𝐞 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞 = $𝟎.𝟗𝟖
Cost of equity for Roblox = 9.5%
If Roblox can return the free cash flow to investors, it will not have any capital to reinvestment, assuming it does not issue equity or raise debt. In that case, growth is 0%.
Roblox’s equity cost decreases at no growth from 9.5% to 6.35% as beta reduces from 1.75 to 1.
𝐀𝐭 𝐧𝐨 𝐠𝐫𝐨𝐰𝐭𝐡, 𝐭𝐡𝐞 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐑𝐨𝐛𝐥𝐨𝐱 = $𝟎.𝟗𝟖/𝟔.𝟑𝟓% = $𝟏𝟓.𝟒𝟑
Roblox pays 100% of its free cash flows as dividends to its shareholder, 𝐑𝐨𝐛𝐥𝐨𝐱 𝐬𝐡𝐨𝐮𝐥𝐝 𝐭𝐫𝐚𝐝𝐞 𝐚𝐭 $𝟏𝟓.𝟒𝟑 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞.
However, Roblox’s current price is $37.04/share.
Thus, 𝐬𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬 𝐩𝐫𝐢𝐜𝐞 𝟓𝟖.𝟑𝟑% (𝟏-𝟏𝟓.𝟒𝟑/𝟑𝟕.𝟎𝟒) 𝐨𝐟 𝐑𝐨𝐛𝐥𝐨𝐱’𝐬 𝐜𝐮𝐫𝐫𝐞𝐧𝐭 𝐩𝐫𝐢𝐜𝐞 𝐭𝐨 𝐟𝐮𝐭𝐮𝐫𝐞 𝐠𝐫𝐨𝐰𝐭𝐡. If Roblox fails to deliver this growth, its share price should fall.
Thus, in my view, the 𝐝𝐢𝐟𝐟𝐞𝐫𝐞𝐧𝐜𝐞 𝐛𝐞𝐭𝐰𝐞𝐞𝐧 𝐠𝐫𝐨𝐰𝐭𝐡 𝐬𝐭𝐨𝐜𝐤𝐬 𝐚𝐧𝐝 𝐢𝐧𝐜𝐨𝐦𝐞 𝐬𝐭𝐨𝐜𝐤𝐬 𝐥𝐢𝐞𝐬 𝐢𝐧 𝐭𝐡𝐞 𝐧𝐞𝐭 𝐩𝐫𝐞𝐬𝐞𝐧𝐭 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐭𝐡𝐞 𝐠𝐫𝐨𝐰𝐭𝐡 𝐨𝐩𝐩𝐨𝐫𝐭𝐮𝐧𝐢𝐭𝐢𝐞𝐬.
If NPV of future growth opportunities >0, income stock becomes growth stock. If the company cannot identify projects with NPV>0, it should 𝐫𝐞𝐭𝐮𝐫𝐧 𝐭𝐡𝐞 𝐞𝐱𝐜𝐞𝐬𝐬 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐭𝐨 𝐬𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬 𝐚𝐬 𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝𝐬 𝐨𝐫 𝐛𝐮𝐲𝐛𝐚𝐜𝐤.