This article was originally published here in April 2002
Last month I talked about the two different styles of investing: Technical analysis and fundamental analysis. I mentioned that there are two sorts of fundamental analysis: Growth investing and value investing. This month I am going to take a closer look at growth investing using a past investment of my own as an example.
Several years ago I got quite interested in spread betting. Explaining what this is could take a whole article but the brief description is that it is a form of betting without fixed odds. I had an account with IG Index, one of the main spread bookmakers. In the middle of 2000 they announced the company was to be floated on the stock market. People with betting accounts were offered shares so I examined the prospectus to see if it was a good investment. If I were examining a company that was already quoted on the stock exchange I would look at its annual report that contains the same information.
The first facts were the offer price was £2.40 and 52 million shares were being issued. That valued the company at £125 million. Was it worth it? The prospectus had the company's accounts for the past three years. The most recent balance sheet showed that the company had net assets of £12 million so with a Price to Book ratio (the market capitalisation divided by the asset value) of over 10 this certainly was not a value investment.
I turned my attention to the profit and loss account. For the years 1998, 1999 and 2000 earnings per share were 1.76p, 5.4p and 15.7p respectively. A quick stab of the calculator showed that profit growth in the year to 1999 profits was just over 3 times and 2000 profits were up by 2.9 times. Amazing growth, but slowing. The prospectus spoke about the future growth the company was expecting. It is always wise to take such statements with a pinch of salt. However, I had noticed an increasing number of articles about spread betting in the papers. It seemed to be joining the mainstream so the future growth of the company did look good.
The key to coming up with an idea of today's value of any growth company is to try to predict future earnings. There are guys in the city paid stacks of money to come up with such predictions but they are really just making informed guesses. I had a play with a spreadsheet and came up with the following:
| Year | 1998 | 1999 | 2000 | 2001 | 2002 | 2003 | 2004 | 2005 |
| EPS | 1.8 | 5.4 | 15.7 | 39.3 | 68.7 | 103 | 134 | 161 |
| EPS Growth | 207% | 191% | 150% | 75% | 50% | 30% | 20% | |
| Prospective P/E | 8.3 | 4.7 | 3.2 | 2.4 | 2.0 |
The figures to 2000 are from the prospectus while the numbers for the next 5 years are my guesses. I gave the company one more year of extremely high growth then assumed that earnings growth falls off. My estimate predicts that by 2005 the company will be earning 160 pence a share.
The flotation price of 240p divided by EPS of 15.7p gave a flotation Price to Earnings ratio (share price divided by EPS) of 15.3. My rough rule of thumb is that a P/E ratio of under 10 indicates a value share while a ratio over 20 signals a growth share. According to my estimation the prospective P/E ratio for 2005 is just 2. A prospective P/E ratio is simply today's price divided by tomorrow's earnings. In 2005 I doubt the actual P/E ratio will be as low as 2. My guess it that it might be around 8. A quick bit of maths (P / E = r, so r x E = P, or 8 x 160 = 1280) predicts a share price of £12.80 by 2005. That is an annual growth rate of 40%, but there is even more to come.
Unusually for a growth company IG Index was proposing to pay a dividend. In 2000 the dividend was 3p so the shares were yielding just 1.25%. The prospectus stated that the directors intended to increase the dividend in line with earnings. They planned to set the dividend at roughly 18% of each years profits. We can use the earnings prediction above to calculate the future dividends.
| Year | 1998 | 1999 | 2000 | 2001 | 2002 | 2003 | 2004 | 2005 |
| Total Div (£m) | 0.3 | 0.4 | 1.3 | 3.1 | 5.4 | 8.1 | 10.5 | 12.6 |
| Div per Share(p) | 0.5 | 0.8 | 2.5 | 5.9 | 10.3 | 15.5 | 20.1 | 24.1 |
| Prospective Yield % | 1.8 | 3.2 | 4.8 | 6.2 | 7.4 |
If we add in the dividends we would receive if we held the shares until 2005 it would improve our expected growth rate by a few percent. More importantly the presence of the dividend will put a floor under the share price. If the price were to fall the dividend yield on the shares increases making the shares more attractive to income investors.
Taking all this into account I thought that the offer price was good value so I bought some shares. After floatation the price rose rapidly, doubling within 5 months. At that point I felt they had gone far enough and I sold my holding. With the benefit of hindsight this proved to be too early as the shares peaked at £6.50 last November. Over the last two months the price has collapsed back to near the flotation price. There seem to be two reasons for this. The founder of this company and its largest shareholder announced his intention to retire. The company also announced results that were well below expectations.
That just goes to show that estimating company earnings is an incredibly difficult thing to do. The trick is to spot when the market's estimation is too low. Buying shares in such situations is the best way to profit from growth companies