Thread by @caprichinvest

A thread to understand growth stocks

As the name suggests growth stocks are which that grows its top line and bottomline for a long period of time.

1. A company grow at 20 % implies that in the previous years the Topline of the company or Its sales has been growing at 20 %

If a company’s sales grow at 20 % then it can double its revenues in ( Il leave it to you to do the math)

Is only topline growth a factor ?

2. Some companies ( mature companies ) have lesser sales growth and have a higher profit growth ( Check mature companies like HUL )

What does this imply ? It means even if they aren’t able to grow their products their operations has positive “Operating leverage” and so most

Of the Top-line flows directly to bottom line. These company’s EPS grows higher than its sales.

3. Why growth is important ? As Warren Buffett mentioned in his 1992 AR that Growth is an important part of the intrinsic value, thus growth is included in value.

4. Which ones to choose ? Growth in Topline shows the company has higher leeway and can grow based on its products or services .

Higher PAT shows the sales is mature but company can compound at a reasonable rate of return.

1st type are the Dmart type stocks 2nd the HUL type

5. Nature of growth stocks ? Many growth stocks who are aggressively investing their cashflows back into the business Will have lesser earnings ( #Amazon in early 90’s) once their capex is done and business starts producing earnings it will be a cash generating machine.

6. Other type of growth stocks are stocks like D-mart with aggressive expansion in Top-line and good earnings with cash flows sometime mostly over valued ( Valuation later )

7. Growth stocks are mostly valued based on their growth which is the main component of its value.

8. How to value growth stocks? Buying a 30 % growing company at 15 P/e looks a easy way to value but that isn’t the correct method.

How to value growth stocks is
1. Growth + ROCE Even if a company grows at 30 % it it’s ROCE is lesser than Cost of capital it is destructive.

Assume a company grows at 30 % , 100 ₹ in sales will become 130 in year 2 but if the ROCE is 8 % and Cost of capital is 10 % then

For additional 30₹ in growth the company has to invest G/R or 0.30/0.08 = 3.75₹ for 1 ₹ of sales or 375 %

Let’s see why this is the case

To simplify this - For 100₹ in sales your company produces 8 ₹ means every 100/8 = 12.5 earns 1 in sales. So for 30 in sales you need 30 x 12.5 = 375 ₹ invested into the business.

A comp that earns high ROCE like 40 % would need only G/R of 0.30 / 0.40 = 0.75 % reinvested.

For every 100 ₹ invested into the business it earns 8% ( ROCE) so if the cost of capital is 10 than (8-10) balance 2 ₹ has to be paid from the company.

So for every ₹ of sales a company has to reinvest a portion of its capital. So in this case we earn 8 and pay out 10.

9. Even if a company has growth if it isn’t earning high returns on capital employed or destructs value and doesn’t add value to growth.

Most of a growth companies cash flows are directed to reinvestment and if Re-inv rate is low it’s not value adding.

10. How else to value growth companies ?

Based on its owner earnings. To put it simply it’s the FCF the amount the owner of a business can take out after adjusting for all expenses.

This is easier said than done but it involves the investor judgement on the future growth.

11. Why we invest in growth stocks is it’s higher leeway for future compounding and it’s high re-Inv rate of these 2 are not there it’s safe to conclude it isn’t a growth stock. Growth stocks has these 2 attributes

We can also use FCF growth but it’s limited to mature companies

Nothing grows to the sky - this is biological similarly are growth stocks - There will be a High growth phase than Slow growth phase and mature phase in life of a business cycle

Even the highest growing company cannot continue for very long time - If it does its 3Sd or outlier

12. Before falling for growth stocks here’s a checklist to remember

1. High growth doesn’t always translate to high earnings

2. If ROCE < COC it will destruct value of a growth comp.

3. Valuing Gr is based on ROCE + Owner earnings + Re-inv rate.

#caprichinvestments