The Rules
I’ll describe two companies. Both are retailers, operating in the US and selling identical merchandise. They are located far enough away from one another that there is no chance of them competing in the same markets for at least ten years.
Both have first year sales of $1,000,000.
Both have an EBIT (earnings before interest and tax) margin of 15% and pay tax at a 33.3% rate.
Therefore, both have first-year earnings of $100,000.
Each firm is publicly traded and has 100,000 shares outstanding. Earnings in year 1 are $1/share for both companies.
Money reinvested in the business is currently generating $2 in sales for every $1 invested. There’s no lag between the decision to invest and the generation of new sales.
Both can borrow up to 20% of earnings from a bank at a variable rate that is now 7%.
Earnings and cash flow are the same (just to keep it simple).
Company 1: Bill’s Stuff
Bill’s management wants to take a conservative approach to a new business. It decides that it will:
reinvest half of its cash flow back into the business,
pay a dividend of $.50 a share ($50,000/year),
keep any remaining cash in reserve in a money market fund.
So, in year 2 Bill’s generates $1,100, 000 in sales, earns $165,000 in ebit and $110,000 ($1.10/share) in net income. It reinvests $55,000 in the business, pays out $50,000 in dividends and keeps $5,000 in reserve.
Let’s assume the company can continue to operate in this manner for as far as we can see. Then, the company’s investment characteristics are:
10% earnings growth rate
$.50 dividend payment
no debt; small but growing amount of cash on the balance sheet
Let’s assume Wall Street is now willing to pay 10x current earnings for the company’s stock.
Company 2: Joe’s Things
Joe’s management believes that expansion opportunities are extraordinarily good right now. It decides that it will:
reinvest all the company’s cash flow back into the business,
borrow the full 20% of earnings that the banks will provide and reinvest that in the business as well.
In year 2 Joe’s generates sales of $1,240,000 and ebit of $185,000. After interest expense of $1,400 and tax, net income is $122,400 ($1.22/share)..
For year 3, Joe’s can borrow another $4,500 and does so. Therefore, it reinvests $126,900 in the business. It generates about $1,500,000 in sales and ebit of $225,000. After interest and tax, net income is about $149,000 ($1.49/share).
Assuming that Joe’s can continue to expand in this manner indefinitely, the company’s investment characteristics are:
22% earnings growth rate,
modest and slowly-rising bank debt,
no current income.
Let’s assume Wall Street is willing to pay 18x current earnings for the stock
The question: Which one would you buy? (Don’t turn the page until you decide!)
The growth stock investor’s answer: Joe’s, of course. Why? I pay $18 for the stock now. At the end of five years, earnings per share will likely be $2.70. Assuming the stock keeps the same p/e multiple, its price will be $48 and I will have almost tripled my money.
Look at Bill’s in contrast. I pay $10 for the stock. At the end of five years, eps will be up 61% and I will have collected $2.50 in dividends (which I may have to pay tax on, but let’s not count that here). Assuming the stock keeps the same multiple, it will be trading at $16.10. Add in the dividends and the total is $18.60. That’s a return of 86%, or about half what I would get from holding Joe’s.
One more thing. Maybe in five years, people will start to worry about whether Joe’s can continue to expand at its current rate. As a result, the p/e multiple could begin to contract. Maybe that will happen, maybe not. But even if it does, the multiple will have to drop from 18 to 12! before I would be better off with Bill’s.
The value stock investor’s answer: It’s obviously Bill’s. Joe’s has a much more aggressive growth strategy. Maybe it will work, maybe not. I don’t see why I have to decide. A lot of the potential reward for success is already built into Joe’s current stock price. And if Joe’s strategy is unsuccessful, the stock has a very long way to fall.
If Joe’s strategy doesn’t work, then I’m much better off with Bill’s. On the other hand, suppose it really is the way to go. In that case, either Bill’s management will see the light and adopt a more aggressive stance itself, or the board or activist shareholders or a potential predator (Joe’s?) will force a change. And the stock will skyrocket. While it may take a little more time, I’ll enjoy all the rewards of backing the winning strategy without taking on the higher risk of holding Joe’s.
It’s a question of temperament. A conversation between the growth and value sides could have several more rounds before it degenerated into name-calling, but you have the basic idea already. Maybe the most salient points to be made about each answer are: not that many companies grow so rapidly as Joe’s without any hiccups; wresting control from an entrenched management is not that easy. It may not be possible, and could be a long and arduous process in any event.