The power of growth stock investing

These notes are from a wonderful book called Benjamin Graham and the power of growth stocks.

Trading versus sitting on it

The advantage of investing in growth stocks is that if you invest at a fair price you can just sit on it and not do anything at all and see your money grow. On the other hand investing in value stocks means you have to sell them once they reach fair value and search for another. You need to keep trading. Both are good methods of investing. Value is cigar butt investing as Warren Buffet calls it- you get a puff free but only a puff. On the other hand, when you invest in growth stocks, you get at least a cigarette, and sometimes unlimited cigarettes.

The Graham formula

Intrinsic value= (8.5 + 2 x growth) x earnings per share x 4.4/y

where y= long term yield on corporate bonds

Do not downgrade P/E ratio by multiplying by 4.4/y unless long term interest rates are going to rise

Valuation

  • Current intrinsic value=(8.5 + 2 x growth) x earnings per share
  • Long term growth rate capped at 20%
  • Intrinsic value in 7 years time= Use growth rate of 7%= P/E of 22.5

Hurdle rate

Hurdle rate-12%. Minimum CAGR that you want to earn on your investment.

Key steps

  1. Be mindful of the power of compound interest
  2. Identify companies with a sustainable competitive advantage
  3. Graham formula to set a value for the company
  4. Set a hurdle rate
  5. Build a margin of safety-know what you own, develop reasonable forecasts, set a reasonable hurdle rate
  6. Take advantage of Mr. market and don’t sell soon
  7. Follow the strategy to build a position in a company over time
  8. Invest for the long term
  9. Overcome outside influences
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4 thoughts on “The power of growth stock investing

  1. TL says:

    Hi, nice blog you have. Regarding your book review of Ben Graham and the power of growth stock, are you able to explain Security Analysis 1962 Edition Chapter 39: Newer Methods for Valuing Growth Stocks – The part under the section “A Different Method Needed”. Not sure how to get $27 for part ‘A’ and $6.30 for part ‘B’. I’m stuck here. Would sincerely appreciate if you could advise and explain. Thanks!

    • Venkata Sreekanth Sampath says:

      The first assumption is a growth rate of 7.2% for the next 10 years.
      So 1 dollar of earnings will grow to 2 dollars.

      The second assumption is that the P/E at end of 10 years is 13.5. So Price at the end of 10 years = P/E multiplied by earnings= 13.5 x 2=27

      The requirement is an annual return of 7.5%. So if you want an annual return of 7.5% then the current value has to be $13. $13 at a rate of 7.5% growth per year will give you $27 at the end of 10 years.

      For the dividend part, we are assuming the average payout to be 60% of earnings. So current dividends=0.6 dollars. This will also increase by 7.2% every year.
      0=0.6
      1=0.6432 =0.6( present value)
      2=0.6895 =0.6
      3=0.7391=0.6
      4=0.7923=0.59
      5=0.8493=0.59
      6=0.9104=0.59
      7=0.9760=0.59
      8=1.0462=0.59
      9=1.1215 =0.58
      10= 1.2022=0.58

      2.95+2.4+1.16= 6.5

      So total value of 1 dollar of earnings = Present value of earnings=13 + Present value of dividends=6.5 = 19.5

      Graham has rounded off things and hence gets a value of 19.3.

      I hope you understand.

      • TL says:

        Hi, thank you so much for the prompt reply. Had a better understanding now.

        However, I’m wondering how the multipier of 13.5 is derived. According to the book, it mentioned: “This multiplier corresponds to an expected growth rate after the tenth year of 2.5%, requiring a dividend return of 5 percent.” I couldn’t get anymore close to 13.5 from here.

        Also, since dividends payout is 60% and dividends comes from earnings, isn’t it sort of like double counting to consider earnings and then add it on with dividends in the calculations?

      • Venkata Sreekanth Sampath says:

        1. The multiplier of 13.5 is an assumption. So if you have growth rates of 2.5%, to get a total return of 7.5%, you need a 5% return from dividends.
        2. Graham has explained this further in this chapter.
        3. Based on graham’s formula: P/E=8.5+2G, so if G=2.5, you get 13.5
        4. Total return and valuation depends on market price and dividends: P/E x E= Price. Dividends are not taken into account. But when you get dividends you need to add that as well, because that is not captured in the price return.
        5. Graham further down the chapter has also given simple ways where the dividend need not be taken into account.
        Hope this helps.

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