Growth and value investing are joined at the hip. –Warren Buffett
The one and absolute truth I have learned about investing–and it is the only one–is that long-range success comes not from any simple rule or rules that can be followed by everyone but only from the most rigorous pursuit of disciplines designed to neutralize the emotional pressures that inevitably descent from time to time upon anyone who is responsible for investing other people’s money.
Those disciplines must be self-evolved because we all have different strengths and weaknesses. the things they have in common are (1) defining precisely what we are trying to do; (2) clearly understanding the reasons for the strategy; (3) recognizing in advance what problems will sooner or later accompany the strategy–for there will always be such problems’ and (4) developing the strength to “stay the course” given during troubled times. Successful investing requires constant inquisitiveness about the new and everlasting, open-minded re-examination of the old. The latter process is more difficult than the former. Not many of us are willing and able to accept the tough disciplines that are involved and not many achieve long-term investment success. –Robert R. Barker, an investor who compounded capital at about a 25% annual rate during the 1950s and 1960s. (1979 Speech)
A Journey to Learn Valuation
I will first focus on how to value growth stocks. There is no promise that we will discover an answer, but we will study the investing greats and their original comments to find our way. Many “great” or famous investors have floundered on the shoals of growth investing. Like Bill Miller: http://executivesuite.blogs.nytimes.com/2008/09/08/bill-millers-really-bad-bet/.
Humbly, we begin by studying the problem of using high and PERPETUAL growth rates when valuing a business. When g is = to r, the result is an absurdity.
The Dividend Discount Model
D1 (Estimate of next year’s dividend) = Current annual dividend * (1 + g)
r (Required Rate of Return for the Stock) = Real Risk Free Rate + (Market Return – Real Risk Free Rate) * Beta of Stock
Real Risk Free Rate = 52-Week T-Bill Yield**
Market Return = Estimate for the stock market’s return in the next year
g (Dividend Growth Rate) = Estimate for the stock’s dividend growth rate (you may calculate g by using the growth of the dividend in the past)
** 52-Week T-Bill Yield – You can find the yield by going to the U.S. Treasury Direct website, selecting the most recent year under auction date > 52-week bills > PDF of the latest auction results.
The Petersburg Complex
This paper by David Durand is a famous article that Ben Graham refers often to in his writings. Growth Stocks and the Petersburg Paradox. If you read only one article from this post, read that. To emphasize the importance of the above article, here is where others have analyzed the article St Petersburg Paradox and Tech Stocks 2000 and St Petersburg Paradox.
The Dangers of Applying Discounted Cash Flow Models
………….NEXT I will post Graham’s discussion on valuing growth stocks.
Just Show ME the Money
One of my favorite blogs: www.greenbackd.com