Companies are broadly divided into two categories: value stocks and growth stocks. Value stocks generally pay higher dividends, have slower growth rates and sell for lower valuations based on traditional metrics like earnings yield (the inverse of the more popular but less easily understood price/earnings ratio), cash flow yield and price-to-book ratios. Growth stocks exhibit more rapid growth using excess cash flow to invest in future growth initiatives. They pay smaller dividends and trade at more expensive valuations, being lower earnings and cash flow yields. Some stocks trading at astronomical valuations can be considered speculations as market participants speculate that earnings will grow so rapidly, eventually the stock will be worth the current price. Or, and more likely, they are speculating they will be able to sell their shares at higher prices regardless of valuation.
I recently read a research report that studied how various valuation metrics impacted future stock performance. In summary, cash flow and free cash flow were the best predictors of future performance. Price-to-book was almost irrelevant and earnings was in the middle of the pack. This report validates my long-held belief that cash flow is more important than earnings. Cash flow is a simpler measure and therefore less prone to manipulation by corporate executives trying to dress up corporate performance for bonuses and stock options.
By way of definition and review:
- Price-to-book = share price/book value per share. Book value is the same as equity per share.
- Earnings yield = earnings per share/share price x 100 per cent
- Cash flow yield = operating cash flow per share/share price x 100 per cent
- Free cash flow = operating cash flow – capital expenditures
Let’s look at how growth rates impact valuations based on two real examples of stocks I own to try to determine which is a better buy. IBM and Roper Technologies are both tech companies oriented toward business customers rather than consumers.
Roper currently trades with earnings, cash flow and free cash flow yields of 3.4, 3.5 and 3.4 per cent, respectively. IBM has much higher yields of 7.1, 13.5 and 10.9 per cent, respectively. The almost irrelevant price-to-book is similar at 5.5 for IBM and 4.7 for Roper. Wouldn’t IBM represent a much better buy with almost double the earnings and triple the cash flow yields? Not so quick.
Over the past 10 years, IBM’s sales have declined by about 25 per cent, but because it repurchased so many shares, sales per share were up marginally. On the other hand, Roper has more than doubled revenue per share. Using the Rule of 72, you can quickly calculate its compound annual growth rate at about 7.2 per cent, not torrid but solid. Like revenue growth, IBM grew cash flow and free cash flow per share by only 10 and 20 per cent over the decade; whereas, Roper more than tripled cash flow and free cash flow per share. IBM pays a 5.2 per cent dividend while Roper’s is just 0.5 per cent. IBM, therefore, meets the definition of a value stock while Roper qualifies as a growth company. Is it worth paying three times the valuation for a growth company like Roper over a value company like IBM? It depends on what the future holds, which is unpredictable.
One of the problems with growth stocks is if growth slows the valuation can decline toward how value companies are priced. If over the next couple of years Roper’s growth flatlines like IBM’s, causing investors to revalue it like a value stock, it could easily drop in half. However, given its history, this looks like a remote possibility. More likely it will maintain its trajectory and triple cash flow again over the next decade.
IBM is interesting because it recently changed CEOs, and if he reignites growth it could move the valuation towards a growth stock valuation, potentially doubling the share price. While a possibility, this is not guaranteed. Microsoft is an example of a company that stagnated, although not as badly as IBM, then a new CEO ignited rapid growth more than tripling the stock valuation. Increasing earnings and cash flow combined with revaluation as a growth company has made the stock a 10-bagger over the past decade. The move between being viewed as a growth versus a value stock is one reason why stock prices can be significantly more volatile than underlying earnings or cash flow.
Both stocks are complementary from a valuation perspective.