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Price, Value and Growth: What's it worth to you?

By Allen R. Jean
March 18th, 2017

What exactly is in a stock price? The implication around this innocuous question can create wealth as much as it can destroy it. To maximize investment returns one must be able to understand clearly the determinants of a stock’s price. By understanding this key factor, investors are better able to guide their portfolios or hire advisors equipped with the proper framework towards investing.

Essentially, the components that determine a stock price is comprised of three parts. This first part is the publicly available information that is available to investors about a company – Public Information. The second part is managements willingness to unlock value from an organizations current state – Value Unlock. The third component is management’s ability to create value from an organizations creativity state – Future Growth.

Public information is simply all the information that is available to all investors. This can be in the form of 10-k’s and 8-k’s, quarterly conference calls, management guidance, etc. This information is analyzed by analysts to determine an expected revenue and earnings figure for the company to report. All things equal, a report issued by the company that is in-line with expectations will justify the current price. A report that surpasses analyst expectations will typically cause the price to readjust to a new level based on the new information available. A report that falls below expectations will send the price down and current prices are readjusted to the new reality.

Value Unlock is the component of price that derives its value from the willingness of management to improve efficiencies within an organization. To realize greater profits management will enact initiatives typically aimed at reduce excess capacity/overhead and/or exit declining markets among other initiatives. Value Unlock is theoretically a low-hanging fruit approach. For example, by spinning off a deteriorating segment from your organization, you can unlock the full value of the organizations current ecosystem, hence increasing the share price. Although it doesn’t require new products or better services, it does require a willingness from management to accept weak points within the company and work to correct them. Even if it means selling the company.

Mergers are another way value can be unlocked. For the purposes of this article we are concerned with the target and not the acquirer. The target company can unlock value that on their own would not have been possible. Thus, increasing returns for its shareholder and putting the company on a surer footing.

Value Unlock is a “hidden” component of an organization, meaning it is not reflected in the current price. Rather it lies beneath the surface of an organization. It would be analogous to the “Acres of Diamond” story by Russell Conwell. Where a man searching for wealth misses a “gold-mine” located beneath his principal property.

Future growth is a component of price that derives its value from the ability of management to create value (rather than unlocking it). A company that rest on its laurels is sure to be cast-aside by future innovators, think of companies like Blockbuster and Service Merchandise. An exceptional management team intuitively understands this and has a dedicated research and development team creating new technologies that will replace older technologies and products. Like Value Unlock, Future Growth is not currently reflected in price. Future growth can be thought of as an alchemistic component of worth in an organization. Meaning that its relation to price is based on the ability of the company to take something ordinary and make it extraordinary. One can refer to their Bible, and see Chapter John 2 verse 1 – 11 to get a sense of alchemistic components of Future Growth.

To express Price mathematically we can assign variables to each piece: Price (p), Public Info (pi), Value Unlock (vu), Future Growth (fg). Thus, price can be represented as p = pi + (x/z(vu) + n(fg)). x/z is the ratio of Value Unlock and n is the multiple of Future Growth.

All things equal, Value Unlock provides an overall lower long-term return then does Future Growth. Consider the following merger scenario between Company T and A:

We have Company T which is worth $50 a share and trading at $25 a share. An acquirer, Company A is interested in Company T. Company A not willing to pay full value offers $40 a share in cash (a gain of $15 a share), which is eight-tenths of $50. Beyond that the shareholders of Company T are limited in their gains.

Note: If Company A in addition to offering cash offered shares to Company T, shareholders of Company T would be able to reap an upside return on the shares issued. In this particular situation there would be both a combination of value (appreciation to $40) and growth (possibility for Company A shares to perform well).

In a pure Future Growth scenario, if we eliminate the Value Unlock variable, we are left with p = pi + n(fg). This Future Growth situation would be viable for any company that has revolutionized a method for production or created a better mousetrap. In doing so we could expect to attach a higher multiple to its Future Growth component in respect to its stock price. If an Internal analysis by management, expects the new mousetrap to generate an additional $10 of EPS over the next 3 years with the bulk coming in as economies of scale in the later years (let’s say $2 in year 1, $3.50 in year 2 and $4.50 in year 3) it may be reasonable to expect that the market may place an additional multiple of, say, 25 on that unexpected future growth. In year 1 that equates to an additional $50 in the stock price. Assuming the stock was trading at $25 as in the previous example the stock is now at $75 per share. Although this is a very simplistic view of the Future Growth, our aim is to depict the superiority of Future Growth over Value Unlock.

In determining Value and Growth we are confronted with earnings multiples. When evaluating stock prices, one is implicitly concerned with the current EPS and the expected growth. The expected growth is an earnings multiple, commonly referred to as P/E. The EPS multiplied by the P/E equals the price.

The expected growth rate should not be confused with future growth. Whereas, the expected growth is based on analyst predictions regarding short-term growth from public information, future growth is based on management’s ability to produce new sources of sales growth through new products and/or new markets for existing products.

Most of us have been taught that low P/E’s represent either a company that has been disregarded by the financial community or a value stock. And that a high P/E represents a stock that is highly favored and a growth stock. They are both right and wrong. Consider the following:

Company X, has an EPS for year 1 – 4 of $1, $1.50, $1.70, and $2.00, with an average P/E of 18, thus producing prices of $18, $27, $36 and $54, respectively. In year 5, due to unusual expenses, the EPS is $0.75, with the market having reason to believe earnings will bounce back next year. They may appropriate a P/E of 66. Given the stock a price of $50.

Does this mean that the Company is now going to break out of its normal earnings growth of 27%? Probably not. Yet to account for unusual expenses adjustments must be made.

Understanding the public information in relation to price one realizes that markets price stocks correctly based on short-term forecasts, which is why most “experts” believe you cannot outperform the markets. Over the short-term they are right. Yet what most do not realize or fail to acknowledge is the true nature of value and growth.

Value is one way in which investors can outperform market expectations. Investors must respect the market in that they are accurate judges of situations in the short-term. Yet over the long-term with all the public information available markets provide opportunities for those willing to dig deep. Value opportunities are routinely touted by “activist” shareholders and when pushed managements are inclined to make changes. Yet, it doesn’t take a Carl Ichan to unlock value. The astute investor who takes time to understand the company can find companies in which the market incorrectly prices a stock.

Another avenue to beating market expectations is future growth. Unlike mainly pushing for efficiency, future growth is created by a superior management team. Management that understands the consequences of complacency and benefits of innovation. A company with the right research and development team and a strong sales and marketing arm. Not only will they be continually pushing exciting products to a willing consumer, they will also have a happier shareholder group. The market is not forward-thinking and the investor that exploits this behavior will find companies on the brink of growth explosion.

Finding these opportunities takes great skill and luck. And although correctly analyzing companies is beyond the scope of this article it is the inherent skill needed to assure great companies are bought at good prices. Luck in locating the company on the brink of a technological revolution with worldwide acceptance is a side effect of diligent research and analysis.