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To learn more, please visit www.iclub.com/ias or see the article in this month's Better Investing magazine.
Special savings at Compufest
Those planning to attend NAIC's CompuFest 2003 in Anaheim later this month, take note! We will be offering special rates for new IAS subscriptions -- just $99 for an online subscription and $119 with the print version included as well. (Normal rates for NAIC members are $115 for the version and $139 for the full print subscription.)
This deal will be available ONLY at CompuFest 2003 from June 27-29, so make sure that you're registered.
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Are you getting the most out of your NAIC Software? Does it ever seem like your personal computer is using you -- instead of the other way around? If so, then NAIC CompuFest 2003 in Anaheim, CA, is the place to be June 27-29, 2003!
At NAIC's computerized investing conference, you can learn tips and strategies for using the power of your computer to build and manage a portfolio. Special programs for teens and their families, as well as for investing Newbies, are available, as as seminars geared towards intermediate and experienced investors. ICLUBcentral staffers will be on hand to help you get started or teach you new techniques for your software, including NAIC Classic, Stock Analyst Plus, NAIC Stock Prospector and NAIC Club Accounting. In addition, you'll discover the best financial web sites to help you research stocks -- all using NAIC's time-tested investing methodology. For more information and to register online, visit
Special Series (6 of 6) - Getting to the Growth Rate
by Scott Horsburgh
When performing a fundamental analysis on a stock, there are three vital issues to be addressed: how fast will earnings grow, what will the price/earnings (P/E) ratio be and what is the current stock price. Multiplying the first two factors will provide a stock price projection, and comparing the projected value to the current price will suggest whether there is money to be made in the stock.
How does one select a growth rate? There are three methods for you to consider:
- Extrapolation – This is simply projecting whatever trend is observable over some period of time. Extrapolation may work with a few very consistent companies like Procter & Gamble, but is not widely recommended. It is the easiest method, but is also prone to the most errors. Extrapolation fails to catch changes in the growth rate, which is the most common reason for dramatic changes (up and down) in a stock’s price.
- Implied growth rate – A company’s “implied growth rate” is the product of its return on equity (ROE) and its earnings retention rate (1 – dividend/EPS). In other words, it is the growth rate that is implied if the company simply reinvests the earnings it keeps rather than pays out as dividends. This method also assumes that the company earns the same return on future capital as it has on capital committed in the past. While it is a big “if” to assume that the ROE remains the same, the math works out properly if the assumptions are met.
- Modifying the implied growth rate method to incorporate other factors:
- Consider the growth rate of the industry and company’s market share. It is easier for companies to grow more rapidly if they are in growth industries such as medical and technology. On a long-term basis, it will be more difficult for a company to grow rapidly in a more mature industry, such as heavy manufacturing. It is quite possible for companies to grow in mature industries when the companies are small, but they start to reflect the characteristics of their industry as they become more significant players in the industry. Consider how Clayton Homes (NYSE: CMH, being acquired by Berkshire Hathaway) continued to grow in the early 1990s, despite severe problems in its industry, when it had only 4% of the manufactured housing market. The same company, under the same management, experienced lower sales and profits during the recent decline in the industry because it now has a much larger share of the market and can no longer avoid the industry’s problems.
- Consider the potential to improve ROE by reducing operating costs or buying back stock. Is the company the low-cost producer in its industry, with perhaps little room for improvement? Is it a good operator with room to get better, thereby improving the net income portion of the ROE calculator? Does it generate excess capital that could be used to buy back stock or institute/increase the dividend? Returning capital to shareholders can increase ROE by reducing the equity capital required to run the business. An example is First Data (NYSE: FDC). First Data generated free cash flow of $1.45 billion in 2002. It used $828 million to pay for acquisitions and another $849 million to buy back 22.9 million shares. Return on ending equity improved from 27% in 2001 to 33% in 2003, due to stronger profit margins (higher return) and lower equity (due to stock buybacks).
- Consider the potential to reduce the total cost of capital by taking on more debt. This can be dangerously alluring to many companies. In this era of low interest rates, the cost of borrowed capital can be much cheaper than the cost of equity capital. The cost of equity capital may run in the range of 10-15%. Capital can cost 10% for blue chip companies versus debt costs of 5-8%. For smaller companies, equity capital may cost 15% while debt can cost 8-9%. Increasing a company’s leverage (i.e. debt/equity ratio) can improve the return on equity, but can also increase the pressure on the company to pay back debt when times become tough.
Forecasting growth is difficult. The easiest methods, extrapolation and simple “implied growth rate,” can also produce the least reliable results. It is important to consider other factors that can influence earnings growth, such as factors that raise sales and profit margins above historical trends or that reduce the cost or quantity of capital needed to run the business.
This illustration is provided for educational purposes only. No securities recommendations are intended. The author owns shares of First Data.
Scott Horsburgh is a research analyst and portfolio manager with Seger-Elvekrog Inc., located in Bloomfield Hills, Michigan.
For more information about Seger-Elvekrog Inc., go to
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