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Growth Stocks and Income Stocks

We often hear investors speak of growth stocks and income stocks. They seem to buy growth stocks primarily in the expectation of capital gains, and they are interested in the future growth of earnings rather than in next year s dividends. On the other hand, they buy income stocks principally for the cash dividends. Let us see whether these distinctions make sense.

Think back once more to Blue Skies. It is expected to pay a dividend next year of $3 (DIV1 = 3), and this dividend is expected to grow at a steady rate of 8 percent a year (g = .08). If investors require a return of 12 percent (r = .12), then the price of Blue Skies should be DIV1/(r g) = $3/(.12 .08) = $75.

Suppose that Blue Skies s existing assets generate earnings per share of $5.00. It pays out 60 percent of these earnings as a dividend. This payout ratio results in a dividend of .60 АГАз $5.00 = $3.00. The remaining 40 percent of earnings, the plowback ratio, is retained by the firm and plowed back into new plant and equipment. (The plowback ratio is also called the earnings retention ratio.) On this new equity investment Blue Skies earns a return of 20 percent.

If all of these earnings were plowed back into the firm, Blue Skies would grow at 20 percent per year. Because a portion of earnings is not reinvested in the firm, the growth rate will be less than 20 percent. The higher the fraction of earnings plowed back into the company, the higher the growth rate. So assets, earnings, and dividends all grow by g = return on equity _ plowback ratio = 20% АГАз .40 = 8%

What if Blue Skies did not plow back any of its earnings into new plant and equipment? In that case it would pay out all its earnings as dividends but would forgo any growth in dividends. So we could recalculate value with DIV1 = $5.00 and g = 0:

Thus if Blue Skies did not reinvest any of its earnings, its stock price would not be $75 but $41.67. The $41.67 represents the value of earnings from the assets that are already in place. The rest of the stock price ($75 $41.67 = $33.33) is the net present value of the future investments that Blue Skies is expected to make. This is reflected in the market-value balance sheet, Table 3.6.

What if Blue Skies kept to its policy of reinvesting 40 percent of its profits but the forecast return on this new investment was only 12 percent? In that case the expected growth in dividends would also be lower: g = return on equity АГАз plowback ratio = 12% АГАз .40 = 4.8%

If we plug this new value for g into our valuation formula, we come up again with a value of $41.67 for Blue Skies stock:

Plowing earnings back into new investments may result in growth in earnings and dividends but it does not add to the current stock price if that money is expected to earn only the return that investors require. Plowing earnings back does add to value if investors believe that the reinvested earnings will earn a higher rate of return.

To repeat, if Blue Skies did not plow back earnings or if it earned only the return that investors required on the new investment, its stock price would be $41.67. The total value of Blue Skies stock is $75. Of this figure, $41.67 is the value of the assets already in place, and the remaining $33.33 is the present value of the superior returns on assets to be acquired in the future. The latter is called the present value of growth opportunities, or PVGO. (Remember that investors expected Blue Skies to earn 20 percent on its new investments, well above the 12 percent expected return necessary to attract investors.) By the way, growth rates calculated as g = return on equity АГАз plowback ratio are often referred to as sustainable growth rates.

THE PRICE-EARNINGS RATIO

The superior prospects of Blue Skies are reflected in its price-earnings ratio. With a stock price of $75.00 and earnings of $5.00, the P/E ratio is $75/$5 = 15. If Blue Skies had no growth opportunities, its stock price would be only $41.67 and its P/E would be $41.67/$5 = 8.33. The P/E ratio, therefore, is an indicator of the prospects of the firm. To justify a high P/E, one must believe the firm is endowed with ample growth opportunities.

WHAT DO EARNINGS MEAN?

Be careful when you look at price-earnings ratios. In our discussion, expected future earnings refers to expected cash flow less the true depreciation in the value of the assets. What is true depreciation? It is the amount that the firm must reinvest simply to offset any deterioration in its assets. In practice, however, when accountants calculate the earnings that are reported in the company s income statement, they do not attempt to measure true depreciation. Instead reported earnings are based on generally accepted accounting principles, which use rough-and- ready rules of thumb to calculate the depreciation of the firm s assets. A switch in the depreciation method can dramatically change reported earnings without affecting the true profitability of the firm. Other accounting choices that can affect reported earnings are the method for valuing inventories, the decision to treat research and development as a current expense rather than as an investment, and the way that tax liabilities are reported.

The dramatic appreciation in stock prices in the late 1990s was attributed by many investors to a new paradigm, where the revolution in information technology would boost company profitability. But the skeptics argued that the run-up in stock prices may be due to accounting problems. The nearby box discusses the possibility that part of the run-up of stock prices relative to earnings in the 1990s, which has worried many stock market observers, may be due to other accounting problems. The article focuses on the distortions created in income statements when investments in research, development, software, and training are treated as expenses which reduce reported earnings, rather than as investments in intangible assets, which would then be gradually depreciated over time.

PAYOUT RATIO Fraction of earnings paid out as dividends.

PLOWBACK RATIO Fraction of earnings retained by the firm.