[Briefing.com] Value or Growth? 02-Feb-01 07:40 ET
[BRIEFING.COM - Michael E. Ashbaugh] So what exactly constitutes a value investment? Price/earnings ratios across the retail/grocery sector generally weigh in with readings in the teens. A great signal for many conventional value investors, yet the sector has put in one of the worst performances over the trailing twelve months. Many tech stocks, on the other hand, have generated substantial one-year returns despite sporting P/E's well into the triple digits.
Financial Fundamentals
The dichotomy between the financial fundamentals of value investments relative to growth investments is frequently the source of confusion, bemusement, or even open mockery in certain cases by proponents of each investment strategy. Not surprisingly, market cycles allow proponents of each strategy to crow at different periods in the cycle. Recent history has made the value investors look like geniuses. But are they?
The only way to answer the question is to quantitatively assess the differences between the two types of investments. Admittedly, this is somewhat unconventional which is why you don't typically see comparisons of this sort. However, each equity investment is comprised of three primary characteristics: 1) the growth dynamics of the business, 2) the value of the business and 3) the risk inherent in both the business as well as the investment.
As a general rule, it's easy to compare growth investments to growth investments and value investments to value investments. However, when comparing growth and value investments to each other, the comparison breaks down due to the risk component. So for the purposes of illustration we'll temporarily set aside risk and press forward with determining whether the growth investor or the value investor has it right.
And In the Value Corner… Weighing In At…
Let's look at some data. As a representative of the value crowd we'll take Procter & Gamble. P&G is a Dow component and has been in business for over a century. Also, it's generally characterized as a defensive investment which is where money flows when indecisiveness strikes the market.
In the growth corner, stands Emulex which has been publicly traded for nearly a decade. Emulex is a widely followed tech stock which makes a wide range of components for storage devices. Emulex is a good example as it's widely considered a growth investment -- an aggressive growth investment by many accounts.
So let's see how PG and EMLX weigh in:
Metric . . . . . . . . . . . . . . . Procter & Gamble (PG) - Emulex (EMLX)
Market Cap . . . . . . . . . . . . . . . . $96.1B . . . . . . . . . . .$7.2B
P/E Ratio . . . . . . . . . . . . . . . . . .29.0x . . . . . . . . . . .178.4x
P/S Ratio. . . . . . . . . . . . . . . . . . . .2.4x . . . . . . . . . . . 35.5x
Operating Margin . . . . . . . . . . . . . .14% . . . . . . . . . . . .31%
Projected 5 Year Growth Rate. . . . . 11% . . . . . . . . . . . .34%
The two prospective investments look quite different. PG has a much larger market cap and on its face has a much more attractive valuation. Yet it has lower operating margins and a slower projected growth rate. On the other hand, Emulex is smaller and has a higher valuation yet its margins and growth rate are very attractive on a relative basis. But which is the better investment?
Assessing Growth Prospects
Some basic math is in order here. Let's take a hypothetical $1 of investment and see what each company will do with it in five years. You could also view this as assessing a hypothetical $1 of each business' revenue. Assuming that the analysts have things right (we'll humor ourselves) PG will grow that $1 of investment by 11% for each of the next five years. By the end of that period, the $1 invested will be worth: (1*1.11)^5 = $1.685
When you remove the original $1 invested from the mix you come away with around $0.69 of growth. The same $1 invested in EMLX over a five-year time horizon yields $4.32 (1*1.34)^5.
Once again, remove the original $1 invested and you're left with $3.32 of growth courtesy of EMLX. So based on revenue growth alone, $1 invested in EMLX is worth about 3.32/0.69 = 4.81 times the $1 invested in PG. Now that's on the basis of topline growth. But we've still neglected to include margins in the assessment just yet. Just how much is each company bringing down to the bottom line?
How Much Money Do These Guys Make?
Operating margins for Procter & Gamble are in the range of 14% whereas Emulex pulls down 31%. If we go back to the $1 invested in each business and treat this exercise as following a hypothetical $1 of revenue we can see how margins impact the decision process. For the purposes of this discussion, we'll ignore the effect of taxes.
The $1 of revenue generated by PG turned into $1.69 over the course of five years. By contrast, EMLX is projected to grow $1 of revenue into $4.32. Again, this is revenue now so we don't need to factor out the original investment. So in five years, PG's $1.69 of revenue on operating margins of 14% will generate $0.24 of earnings.
EMLX over the next five years will generate $4.32 of revenue on operating margins of 31% turning out $1.34 of earnings. So the relative difference between the two businesses is EMLX will produce 1.34/0.24 = 5.58 times the earnings PG will produce over the next five years.
And What Exactly Does All of This Mean?
Well this is where the price/earnings ratios become useful. To place P&G in EMLX terms, PG is valued at about 29 * 5.58 = 161.9 on a dollar of revenue projected five years out and adjusted for margins. Or to place EMLX in PG terms, EMLX is worth 178.4/5.58 = 32 again on a dollar of revenue projected five years out and adjusted for margins.
So in value language the valuation is: EMLX = 32.0 PG = 29.0
Or if you prefer growth terminology the comparison is: EMLX = 178.4 PG = 161.9
Maybe These Two Look More Alike Than We Thought
By definition, either way you cut the numbers PG looks like the slightly better value assuming that analyst projections are correct and the relative difference in margins remains in the ballpark of the status quo. But it's interesting to see that the difference between these two is not that great. An investor purchasing shares of EMLX is paying a premium of about 10% relative to PG. A far cry from the glaring 515% difference in the TTM P/E ratios previously listed. So when you get in and look under the hood maybe these two investments are more fairly matched than it originally appeared on the face of things.
Once again, it's worth noting this comparison between EMLX and PG has been assessed solely on the basis of the relative growth dynamics and the relative value of each business. As mentioned earlier, risk is much more difficult to get at as it accounts for visibility of earnings, quality of the product line, the potential for competitive threats and a host of other unforeseen possibilities. Risk is very difficult to measure indeed.
Nonetheless, in a sense we just quantified the risk between these two investments. In the aggregate, investors are willing to pay about 10% more on a five-year time horizon for the privilege of owning EMLX over PG. So the EMLX investor is willing to risk 10% more, all things being equal, to get at the more attractive growth dynamics. If both companies perform over the next five years as assumed, EMLX will continue to maintain a gap in its valuation on the relative basis illustrated. That gap will represent the amount by which EMLX outperforms PG.
Back to the Future
In other words, we were looking at a snapshot of what these investments would look like today with the benefit of hindsight five years from now. What will actually unfold is more like a movie that breathes with changes in the performance and prospects for both PG and EMLX.
Keep in mind this is just one method of cutting the numbers. It's based on two random companies, one set of projections, one time horizon, and the assumption that relative differences do not change. The permutations for the prior variables are infinite. This is what makes for lively debate and substantial opportunity in the markets.
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