Its Value + Growth not Value versus Growth
Most pundits (and index creators) talk about value investing in contrast to growth investing and view value investing as investments in stocks selling at low prices relative to some underlying fundamental measure such as book value, earnings, sales or cash flow. They classify stocks with low multiples as value stocks and those with high multiples as growth stocks. This is not how we view value investing. Value investing is about finding companies selling at reasonable prices given their current and future prospects for generating cash flows to the owners – this naturally includes elements of both value and growth.
Lets get mathematical. There are many ways of valuing a stock and each of them can be used to generate a formula that can show this relationship between value and growth. For those with more interest in valuation methods including the one used here will find a more detailed analysis in our book on Equity Asset Valuation 4th Edition, by Pinto, Henry, Robinson, Stowe and Wilcox published by CFA Institute an Wiley and included in the CFA Program curriculum. (Full disclosure I earn no royalties or any other compensation on sales of this book).
We can view the value of company as the present value of all future free cash flows available to the equity investors. Free cash flows to equity holders in this context is the cash flow generated from operations less investments needed to maintain and grow fixed capital (such as equipment) and net debt repayments. In the simplest model this can be computed as:
Current Value = Free Cash Flow to Equity / (Equity investors required rate of return minus the expected future growth rate of free cash flow to equity)
Lets simplify using abbreviations and assume that the current value should be equal to the current price it does not have to be as we ideally want to find stocks whose price is lower than our computed current value. However, this initial assumption allows us to compute an expected return based on the current price.
So:
P = FCFE/(r-g)
Now lets apply some algebra concepts and rearrange the formula:
P * (r-g) = FCFE
Then:
r-g = FCFE/Price
and:
r = FCFE/Price + g
This tells us that given that the initial assumption that Price is equity to Current Value the expected return on an investment is equal to the current cash flow yield (how much free cash flow is generated per the price paid) and the expected future growth in cash flow.
Returning to plain English:
Expected Return = Cash Flow Yield + Future Growth in Cash Flows
Cash flow yield is a value measure (the inverse of a price multiple based on cash flow) and growth is growth. So any investment in equities should have both value and growth components. Value investing should involve finding great companies selling at reasonable prices relative to both their current fundamentals (such as cash flow) and their future ability to grow those fundamental measures.
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