Hi there,
A bit ashamed to say that I am still a bit confused how growth stocks actually produce their returns for their shareholders over time. More specifically the actual mechanics of it. Please bear with me:
Let's say you buy one stock of a tech company today at t=0 at a rather high 1yr forward P/E ratio. Now fast forward one year to t+1. Suppose the earnings announced at t+1 are exactly those implied by 1yr forward P/E ratio a year ago at t=0.
At t+1 we realized one year of earnings. The remaining future earnings are unchanged minus what we just realized at t+1. Basic algebra tells me that stock price should appreciate by the difference in value of all discounted future earnings at t=0 and t+1.
If we look at classic DCF valuation, in % terms that difference is the discount rate or cost of equity. That stock's market price should appreciate by the cost of equity of that tech firm = risk-free rate + beta x equity risk premium.
Is my thinking correct?
If a company hits estimates and does not guide up/down, theoretically speaking their return should follow capm/apt. So expect a ~6% * beta return on your stock. Valuation creeps down because price is not moving faster than eps typically (though this is very contextual).
The primary mechanism for a growth stock to outperform a market is through a period of earnings momentum. This is a case where earnings are improving rapidly (company has found scale), which forces analysts to revise higher. The market is not great at pricing in growth because of behavioral issues (people tend to extrapolate current trends), which tends to miss earnings acceleration. This causes a sequence of analyst revisions higher over quarters-years.
This then drives momentum as the company stays in the news every quarter because of beats & “social proof”.
If you think about it from a DCF standpoint— it means every quarter you are revising your fcf outlook higher.
Where a company is not driving changes in future estimates, it should not outperform outside its apt/capm range unless there are some idiosyncratic factors at play. For example, a merger or spin off.
Thanks a lot. Only two responses to my query here but both hit the target for me.
Here's a way to think about how a growth stock should be priced, and why the stock should go up, given some simplifying assumptions in a perfectly efficient market.
1. Cost of capital is 10%
2. Mature companies grow net income at 0%, and thus mature companies trade at 10x earnings and have 100% FCF conversion
3. Our growth company, is currently earning $4/share annually, and will grow its earnings at a 20% CAGR per year for the next 5 years, and then it becomes mature and stops growing. Thus, over 5 years earnings will go from $5 to ($5 * 1.2^5) = ~$10. However, in its growth period it will not have any FCF to distribute as it reinvests fully into growth
4. This means that at maturity, 5 years from now, the stock will be worth ~$100 ($10 EPS * 10x multiple)
5. The initial p/e of the stock in an efficient market will be such that the stock yields an annual 10% return, given our 10% cost of capital. To get an annual 10% return, the stock needs to begin at a ~$62 price, or a 15.5x P/E, to yield a 10% return
6. In our perfectly efficient market, the company would rise smoothly from $62 to $100 in its growth phase, and then would remain at $100 if it paid out its earnings yield in dividends or would rise 10%/year if it bought back shares with its yield
To sum up, in a perfectly efficient market the market knows that growth does not continue indefinitely above cost of capital (this is key), and then prices the stock based on projected terminal value of steady state growth (or based on complete cash flows if the company eventually winds down), discounting that terminal value back at the cost of capital. If the growth stock just keeps growing at 20% forever, its theoretical value is infinite and all of this just breaks down.
In practice, this isn't really what actually happens. Let's consider that hypothetical growth company again from my earlier example.
1. We exist in a state of uncertainty. Even if the weighted probability is that the company gets to that $100 of earnings over 5 years, other outcomes are possible. Each time the company delivers on its 20% growth rate, the market increases the probability it will be get to $100, or possibly exceed $100. Thus, if the company delivers its 20% growth there's a very good chance the stock will outperform its cost of capital because a bad outcome (missing earnings) is off the table.
2. Similarly, if the company vastly exceeds that estimate of 20% annual growth in a given year, the market will have to re-adjust its projects to adjust for the higher earnings figures the company is delivering, and also factor in the perhaps-increased likelihood that the company can remain a growth company for longer than the initial 5 years
3. And if the company matures more quickly and stops growing, then the market has to price in the lack of future growth and the stock will fall to 10x earnings, reflecting its mature status.
Put another way, the market is always trying to calibrate to a price that delivers the cost of capital, and surprises against market expectations can force a significant re-evaluation of what prices is necessary to deliver that outcome over time.
On your example, your approach is a bit hard to work with because the company now has cash on its balance sheet which it can disburse back to shareholders, and your DCF needs to factor that in in some fashion. If the company is not generating free cash flow, then your updated stock price after year 1 should simply reflect that the terminal state is 1 year closer than it was (which gets you back to my framework).
Thanks a lot that is really the insight that I needed. It essentially confirms to me that at least theoretically stock price appreciation is rooted in its cost of capital.
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