Yes, I was supposed to be writing about trading. But I figured it might be useful for readers to figure out whether they tend to like growth stocks or value ones before going further. Here’s a test I heard about while I was at a value-oriented shop in the early 1990s (it’s a rerun of a one of the first posts I wrote in 2009. Try not to look back to see the answers, which will appear again tomorrow.):
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 dividend.
Let’s assume Wall Street is willing to pay 18x current earnings for the stock
The question: Which one would you buy?