{"id":23713,"date":"2021-01-22T18:06:08","date_gmt":"2021-01-22T22:06:08","guid":{"rendered":"https:\/\/www.shortform.com\/blog\/?p=23713"},"modified":"2021-01-24T18:09:29","modified_gmt":"2021-01-24T22:09:29","slug":"how-to-value-growth-stocks","status":"publish","type":"post","link":"https:\/\/www.shortform.com\/blog\/how-to-value-growth-stocks\/","title":{"rendered":"How to Value Growth Stocks: Important Formulas"},"content":{"rendered":"\n<p>Do you want to know how to value growth stocks? What strategies can you use for valuing stocks?<\/p>\n\n\n\n<p>Learning how to value growth stocks can help you choose the right stocks to invest in. Benjamin Graham offers a formula for valuing stocks in <em>The Intelligent Investor<\/em>.<\/p>\n\n\n\n<p>Keep reading to find out how to value growth stocks.<\/p>\n\n\n\n<!--more-->\n\n\n\n<h2 class=\"wp-block-heading\">Formulas for <strong>How to Value Growth Stocks<\/strong><\/h2>\n\n\n\n<p>Growth stocks are growing rapidly, and using their historical performance may underestimate the company\u2019s value in the future. Can you learn how to value growth stocks?<\/p>\n\n\n\n<p>Graham thus proposes the following formula for growth stocks:&nbsp;<\/p>\n\n\n\n<p><strong>Company Value = Current Earnings x (8.5 + 2x expected annual growth rate over next 10 years)<\/strong><\/p>\n\n\n\n<p>(Shortform note: This simple formula became popular and is now known as the Benjamin Graham formula.)<\/p>\n\n\n\n<p>This formula represents the company\u2019s total market capitalization in dollars. The current earnings is factual and found through the company\u2019s financial statements. The expected annual growth rate is a prediction about the future and thus subjective. (Graham doesn\u2019t give specific guidance on figuring out a company\u2019s growth rate, other than considering the general factors in the last section.)<\/p>\n\n\n\n<p>The formula for how to value growth stocks can also be rearranged to figure out the company\u2019s proper value to earnings ratio (also known as price to earnings ratio, or P\/E):<\/p>\n\n\n\n<p><strong>Value \/ Earnings = 8.5 + 2x expected annual growth rate<\/strong><\/p>\n\n\n\n<p>For example:<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li>A company with an expected annual growth rate of 20% could justify a P\/E ratio of 48.5 (8.5 + 2*20).<\/li><li>A company with an expected annual growth rate of 10% could justify a P\/E ratio of 28.5.<\/li><li>A company with an expected annual growth rate of 0% could justify a P\/E ratio of 8.5.<\/li><\/ul>\n\n\n\n<p>The formula for how to value growth stocks can be reordered to figure out what the market believes the company\u2019s growth rate will be, based on its current stock price:<\/p>\n\n\n\n<p><strong>Expected annual growth rate = (P\/E ratio &#8211; 8.5) \/ 2<\/strong><\/p>\n\n\n\n<p>For example, if the market prices a company\u2019s stock at a P\/E ratio of 20, it believes the company will grow earnings by 5.75% every year.<\/p>\n\n\n\n<p>These formulas help you determine whether a company\u2019s stock is over- or undervalued as you strategize on how to identify growth stocks.<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li>If, through your analysis, you find that a company\u2019s fair value is $500 million, but its current market capitalization is lower at $400 million, the stock may be a bargain.<\/li><li>Likewise, if you believe a company\u2019s value is $500 million but its market value is $1 billion, the stock may be highly overpriced and need to achieve incredible growth to earn its valuation.<\/li><\/ul>\n\n\n\n<p>(Shortform note: Graham doesn\u2019t discuss situations where the company\u2019s earnings are currently negative, as is the case with many public companies today. They likely wouldn\u2019t meet his criterion for safety and would see investing in these companies as too speculative for most investors.)<\/p>\n\n\n\n<h4 class=\"wp-block-heading\"><strong>Accounting Shenanigans<\/strong><\/h4>\n\n\n\n<p>While we\u2019ve treated earnings to be a fairly dependable number, in practice <strong>companies may use accounting sleight of hand to make their financials look more promising<\/strong>.&nbsp;<\/p>\n\n\n\n<p>For instance, a company might present a business expense such as taxes on stock options as an \u201cextraordinary nonrecurring event,\u201d saying that it\u2019s not part of normal business. It then shows \u201cpro forma\u201d earnings that ignore this expense.<\/p>\n\n\n\n<p>Using techniques like this usually isn\u2019t outright illegal; rather, it takes accounting tools that have reasonable intended purposes and stretches them to the edge of plausibility when learning how to value growth stocks. <\/p>\n\n\n\n<p>Graham and Zweig highlight some common tricks to be aware of as you learn how to identify growth stocks:<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li><strong>Timing of losses:<\/strong> When a company\u2019s project fails, it typically reports a loss on it in the year that it actually takes the loss (such as when it closes down a factory). However, some companies may report a loss early under the guise of \u201canticipating future losses,\u201d reporting the loss well before it actually happens.&nbsp;<ul><li>Why would a company do this? To take advantage of investor expectations\u2014if the stock market has had a bad year and investors have already resigned their expectations for the company, it\u2019s a good time to declare possible future losses. In essence, this shifts the loss from future years to the current year, thus making future years\u2019 earnings higher.<\/li><\/ul><\/li><li><strong>\u201cSpecial\u201d, \u201cextraordinary\u201d or \u201cone-time\u201d items:<\/strong> These are one-time charges or revenues that the company believes is not indicative of normal operations and won\u2019t recur in future years. Examples of legitimate extraordinary items include a regulatory fine or eliminating debt. However, some companies may improperly report regular business expenses as \u201cone-time charges,\u201d which makes company earnings look better than they really are. A regular pattern of \u201cone-time\u201d items appearing more than one time is a red flag.&nbsp;<\/li><li><strong>Choice of depreciation:<\/strong> How a company chooses to depreciate assets will affect its earnings. In particular, if a company changes its choice of depreciation from one year to another, it can cause a short-term change in earnings that doesn\u2019t represent any material differences in the business.<\/li><li><strong>Pro forma financials:<\/strong> While GAAP accounting (Generally Accepted Accounting Principles) is the standard for financial reporting, companies may report alternative \u201cpro forma\u201d financials, which pretend as though certain items are not part of normal operations. One legitimate use of pro forma financials is during a <a href=\"https:\/\/www.shortform.com\/blog\/business-acquisition-strategy\/\">business acquisition<\/a>, to show the acquirer how the business would operate when acquired. However, during the <a href=\"https:\/\/www.shortform.com\/blog\/dotcom-bubble-zero-to-one\/\">dotcom bubble<\/a>, many companies improperly used pro forma financials to inflate their earnings.<\/li><li><strong>Aggressive revenue recognition: <\/strong>Say a company sells a product that the customer pays for over the course of months or years. Realistically, the cash goes from the customer over this long period of time. However, the company may \u201crecognize\u201d the revenue over years as having been collected instantaneously at the moment of the sale. This inflates revenues and can overestimate the solidity of the business, particularly if the customer later stops paying.<\/li><li><strong>Treating normal expenses as capital expenditures:<\/strong> A company may report normal operating expenses as capital expenditures. This allows the company to boost assets on its balance sheet and take less of a hit on its net income.<\/li><li><strong>Over-optimistic pension projections:<\/strong> A company with a pension will estimate how much money it needs to pay future pensions. When a company earns more than this estimated amount, it can report the difference as net income. However, a company can also artificially change this number by changing its estimations.&nbsp;<ul><li>For instance, a company might previously estimate its pension plan would grow at 6% per year. If it suddenly improved the estimate to 8% per year, it would need less money today to meet future obligations. This presents an artificial \u201cgain\u201d that can be reported as net income.<\/li><li>Pay attention if the \u201cnet pension benefit\u201d is a big portion of the company\u2019s net income\u2014say, over 5%.<\/li><\/ul><\/li><\/ul>\n\n\n\n<p>The details of corporate accounting can be abstruse and difficult to unpack. One reliable way around these shenanigans is to <strong>use a long period of earnings, say 10 years, with all the adjustments added in. Don\u2019t rely solely on a single year\u2019s earnings for your investment decisions.<\/strong><\/p>\n\n\n\n<p>When studying a company\u2019s financials, <strong>beware of any reported changes in the company\u2019s accounting methods<\/strong>. These are opportunities for companies to inflate performance over previous years when you have to learn how to identify growth stocks. <\/p>\n\n\n\n<p>(Shortform note: Accounting regulation is an ever-changing field. In reaction to major accounting frauds such as Enron and Worldcom as well as the <a href=\"https:\/\/www.shortform.com\/blog\/dot-com-bubble-burst\/\">dotcom crash<\/a>, the Sarbanes-Oxley Act of 2002 was passed in the United States to standardize financial reporting and decrease flexibility of some of the tools mentioned here. However, as Graham notes, companies will always find creative ways to toe the line of regulation.)<\/p>\n","protected":false},"excerpt":{"rendered":"<p>Do you want to know how to value growth stocks? What strategies can you use for valuing stocks? Learning how to value growth stocks can help you choose the right stocks to invest in. Benjamin Graham offers a formula for valuing stocks in The Intelligent Investor. Keep reading to find out how to value growth stocks.<\/p>\n","protected":false},"author":5,"featured_media":23104,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_jetpack_memberships_contains_paid_content":false,"footnotes":""},"categories":[45,81,31],"tags":[184],"class_list":["post-23713","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-business","category-economics","category-money","tag-the-intelligent-investor","","tg-column-two"],"yoast_head":"<!-- This site is optimized with the Yoast SEO Premium plugin v24.3 (Yoast SEO v24.3) - https:\/\/yoast.com\/wordpress\/plugins\/seo\/ -->\n<title>How to Value Growth Stocks: Important Formulas - Shortform Books<\/title>\n<meta name=\"description\" content=\"Do you want to know how to value growth stocks? 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She wrote her first short story at the age of six, about a lost dog who meets animal friends on his journey home. Surprisingly, it was never picked up by any major publishers, but did spark her passion for books. Carrie worked in book publishing for several years before getting an MFA in Creative Writing. She especially loves literary fiction, historical fiction, and social, cultural, and historical nonfiction that gets into the weeds of daily life.\",\"url\":\"https:\/\/www.shortform.com\/blog\/author\/carrie\/\"}]}<\/script>\n<!-- \/ Yoast SEO Premium plugin. -->","yoast_head_json":{"title":"How to Value Growth Stocks: Important Formulas - Shortform Books","description":"Do you want to know how to value growth stocks? 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