A company that grows 5% per year vs. a company that grows 10% per year

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Virus4762
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A company that grows 5% per year vs. a company that grows 10% per year

Post by Virus4762 » Sun May 06, 2018 1:00 am

I’m going to give an oversimplified example here: Say there were two 20 year old companies that were exactly the same in every way except one had been increasing its net income (and free cash flow) by 5% every year since inception (company A) and the other one had been increasing its net income (and free cash flow) by 10% every year since inception (company B). Also, say that each of these two companies were expected to continue growing at their respective past growth rates. A valuation is run on each company and it is determined that each company is fairly valued (each company is valued at $100 a share which happens to be the price that each company is trading at (company B had more shares outstanding than company A)).

Which company would you consider the better investment? I realize how stupid this question sounds because even though company B is growing much faster than company A, that extra amount of expected future growth should be accounted for in the valuation of the company and theoretically be priced in to its current stock price but could it be assumed that the greater efficiency of company B could be a greater harbinger of future outperformance when compared with company A’s? Which company would you personally invest in? Or would you consider it an obvious wash?

Thanks

Tal-
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Re: A company that grows 5% per year vs. a company that grows 10% per year

Post by Tal- » Sun May 06, 2018 2:29 am

I think you're confusing the value of an individual stock, with a company's total value.

If Company A has 10 stocks outstanding, the value of that company is $1000. That is the key number. Now, you can think of your $100 as buying 10% of the company. Note that this is true if stock price were $5, but there were 200 shares - your $100 would still buy 10% of the company.

In your example, company B has more shares outstanding and the same stock price. By definition, that company is worth more.

Given that, let me rephrase your question: Is it better to own a larger portion of a stable company (value) or a smaller portion of a company that is growing at a fast pace (growth)? This question of value vs growth is age-old, and one that investors always struggle with.

But, leaving the hypothetical and returning to the real market, the answer is clearly "both." Whether you use index funds, actively managed mutual funds, or individual stocks, the best known process is to own both value and growth stocks.
Debt is to personal finance as a knife is to cooking.

AlohaJoe
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Re: A company that grows 5% per year vs. a company that grows 10% per year

Post by AlohaJoe » Sun May 06, 2018 2:45 am

Virus4762 wrote:
Sun May 06, 2018 1:00 am
A valuation is run on each company and it is determined that each company is fairly valued
If you're going to assume that "each company is fairly valued" then that's very definition of them being equally good investments.

(I don't understand what you're trying to learn from this thought exercise.)

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JoMoney
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Re: A company that grows 5% per year vs. a company that grows 10% per year

Post by JoMoney » Sun May 06, 2018 2:46 am

What if one of the companies was taking on a lot of debt to grow faster in a highly cyclical industry, and at a higher risk of bankruptcy?
What if these companies were competitors in the same industry, the slower growing one having a huge share of market and huge advantages of scale, whereas the other might have grown fast when in was small serving a niche market, but will hit a plateau when trying to compete for market share with the bigger one?

I would assume both companies are likely already in my broad market index fund, and that I likely don't know enough about the particulars of it's industry.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

Virus4762
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Re: A company that grows 5% per year vs. a company that grows 10% per year

Post by Virus4762 » Sun May 06, 2018 8:03 pm

Tal- wrote:
Sun May 06, 2018 2:29 am
I think you're confusing the value of an individual stock, with a company's total value.

If Company A has 10 stocks outstanding, the value of that company is $1000. That is the key number. Now, you can think of your $100 as buying 10% of the company. Note that this is true if stock price were $5, but there were 200 shares - your $100 would still buy 10% of the company.

In your example, company B has more shares outstanding and the same stock price. By definition, that company is worth more.

Given that, let me rephrase your question: Is it better to own a larger portion of a stable company (value) or a smaller portion of a company that is growing at a fast pace (growth)? This question of value vs growth is age-old, and one that investors always struggle with.

But, leaving the hypothetical and returning to the real market, the answer is clearly "both." Whether you use index funds, actively managed mutual funds, or individual stocks, the best known process is to own both value and growth stocks.
I was never trying to imply that company B wasn't worth more but I see where your going with your rephrasing - there's something that doesn't make sense to me though: Is it better to own a larger portion of a stable company (value) or a smaller portion of a company that is growing at a fast pace (growth)?

It seems that this question implies that company B isn't stable - yes, it's growing at a faster rate but could that really be conflated with instability (keep in mind that it's been growing at the exact same rate (albeit a faster rate than company A) since inception)?

Virus4762
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Re: A company that grows 5% per year vs. a company that grows 10% per year

Post by Virus4762 » Sun May 06, 2018 8:12 pm

AlohaJoe wrote:
Sun May 06, 2018 2:45 am

(I don't understand what you're trying to learn from this thought exercise.)
Can future growth ever truly accurately be priced in to the current price of the company. Nine times out of 10, it seems like the higher a company's past growth is, the more it's future growth is underestimated. You think it would be the opposite. I'm thinking mostly of FANNG and the like.

AlohaJoe
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Re: A company that grows 5% per year vs. a company that grows 10% per year

Post by AlohaJoe » Sun May 06, 2018 8:15 pm

Virus4762 wrote:
Sun May 06, 2018 8:12 pm
AlohaJoe wrote:
Sun May 06, 2018 2:45 am

(I don't understand what you're trying to learn from this thought exercise.)
Can future growth ever truly accurately be priced in to the current price of the company. Nine times out of 10, it seems like the higher a company's past growth is, the more it's future growth is underestimated. You think it would be the opposite. I'm thinking mostly of FANNG and the like.
No, the future can't be predicted with any significant accuracy.

Tal-
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Re: A company that grows 5% per year vs. a company that grows 10% per year

Post by Tal- » Sun May 06, 2018 8:37 pm

Virus4762 wrote:
Sun May 06, 2018 8:12 pm
AlohaJoe wrote:
Sun May 06, 2018 2:45 am

(I don't understand what you're trying to learn from this thought exercise.)
Can future growth ever truly accurately be priced in to the current price of the company. Nine times out of 10, it seems like the higher a company's past growth is, the more it's future growth is underestimated. You think it would be the opposite. I'm thinking mostly of FANNG and the like.
Predicting the future of the company is really what valuation is all about. Caterpillar (?) just shared their quarterly results - revenue and profits beat estimates, but their outlook was somewhat negative. And, despite the strong past performance, the stock price declined because the outlook is far more important (I may be off on Caterpillar's specifics here, but that was the theme).

On the other hand, look at Tesla - a stock whose primary merit is it's growth. It loses money today, and is valued at more than $50 Billion. Whether earnings at Tesla will ever increase enough to justify that valuation is impossible to say - but the market thinks that it will...

If you ask me to predict whether Caterpillar's stock will outperform Tesla over the next 5 years (% increase), I'd ask my magic ball, and tell you, "reply hazy try again."

With that said, I'd argue that past growth rate is valuable, if for no other reason than it is thought to inform future growth rate. But, I can't quantify this...
Debt is to personal finance as a knife is to cooking.

randomguy
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Re: A company that grows 5% per year vs. a company that grows 10% per year

Post by randomguy » Sun May 06, 2018 10:18 pm

Virus4762 wrote:
Sun May 06, 2018 8:12 pm
AlohaJoe wrote:
Sun May 06, 2018 2:45 am

(I don't understand what you're trying to learn from this thought exercise.)
Can future growth ever truly accurately be priced in to the current price of the company. Nine times out of 10, it seems like the higher a company's past growth is, the more it's future growth is underestimated. You think it would be the opposite. I'm thinking mostly of FANNG and the like.
Up until they day it gets overestimated and the stock crators😁. For companies like fanng, look how their processors like Intel, Microsoft, Oracle, hp, Dell, and the like have aged.

Momentum is awesome and works well. Til it doesnt

HEDGEFUNDIE
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Re: A company that grows 5% per year vs. a company that grows 10% per year

Post by HEDGEFUNDIE » Mon May 07, 2018 9:26 am

Look up discounted cash flow analysis. It’s how professionals do equity valuation.

Basically, valuing a company is more than just predicting its future cash flows; it also requires an analysis of the riskiness (or volatility) of those cash flows. Changes to either parameter of the equation will affect total valuation (and thereby current stock price)

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