CFA Institute

A Method of Evaluating Growth Stocks

Author(s): Julian G. Buckley
Source: Financial Analysts Journal, Vol. 16, No. 2 (Mar. - Apr., 1960), pp. 19-21
Published by: CFA Institute
Stable URL: http://www.jstor.org/stable/4468983
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 A Method of Evaluating Growth Stocks
by Dr. Julian G. Buckley -i

IN THE PAST FEW YEARS the term "growth company Table I

has been frequently used by Security Analysts and in- International Business Machines Corporation
vestors. Some of the characteristics ascribed to growth x Y* XY
companies include: (1) rapid sales increase over an 1939 0 9.1 0
extended period of time; (2) new product development 1940 -1 9.4 9.4
of an alert research department; (3) large capital ex- 1941 -2 9.8 19.6
penditures; (4) high depreciation charges; (5) low 1942 3 8.7 26.1
1943 4 9.2 36.8
dividend payments compared with earnings; (6) fre- 1944 5 9.7 48.5
quent stock dividends; and (7), above all, aggressive 1945 6 10.9 65.4
and able management. 1946 7 18.8 131.6
In short, if a company has several of the above at- 1947 8 23.6 188.8
tributes, it is usually accepted as a growth company. 1948 9 28.1 252.9
Consequently, its stock reflects the expectation of a con- 137.3 779.1
tinued growth of earnings by selling at a high price-
iXY 779.1
earnings ratio. Further, as is often the case, Analysts M= _- 5.67
become so bemused by a growth company that they 2Y 137.3
often fail to study the basic factor: the growth rate of M = 5.67
net income. :Net income in millions of dollars.
It is believed that the growth rate of net income of a
company should be calculated for a 10-year period.
This can be compared profitably with similar companies Table II*
in the same industry. In addition, it is possible by Mean Value to Fit Exponential Growth Curve
using the growth rate to project the past 10 years' earn- n 10 years
ings trend forward another 10 years and estimate the r M r M
earnings of a company at that time. This would of 1.025 4.70 1.105 5.31
course assume that the same rate of growth is main- 1.035 4.78 1.115 5.38
tained. While the projection of past records into the 1.045 4.86 1.125 5.45
future earnings might seem to be an invalid method of 1.055 4.94 1.135 5.52
estimating growth, it does serve as a tool for comparison 1.065 5.01 1.145 5.58
1.075 5.09 1.160 5.67
of various securities. We will endeavor to show that 1.085 5.17 1.180 5.80
it is useful to compare the estimated earnings of several 1.095 5.24 1.200 5.92
companies in 1968 based on a formula, together with Tables of Applied Mathematics in Finance, Insur-
their prices at the end of 1959. ance Statistics. Editor James W. Glover, p. 473,
An example might be taken of the growth rate of 1930. George Wahr Publishing Co., Ann Arbor,
earning for International Business Machines Corpora- Michigan. Reproduced by permission.
tion for the years 1939-1948, as shown in Table L.
Using Table l's correlation techniques, a measure Since it is assumed that the Table II calculation was
can be found that shows the annual rate of earnings made in 1949, a time when the earnings for 10 years
growth. from 1939 through 1948 were available, it might be
Applying Glover's tables for the value of M or 5.67, interesting to forecast the earnings for 1958. This can
see Table II, it will be seen that r equals 1.160. This be done by selecting the equation to the simple expo-
means that the annual rate of increase of earnings of nential curve, as follows: y arx.
International Business Machines Corporation from As has been demonstrated above, r equals 1.160, or
1939 to 1948 was about 16%. a growth rate of 16% for the 10 years 1939 to 1948;
and x, in this case, will equal a 20-year period from
Dr. Julian G. Buckley is an associate professor of finance at 1939 to 1958. Also, y will equal the net income of
New York University's Graduate School of Business Adminis- International Business Machines Corporation in 1958,
tration. He is a financial consultant and corporate director. assuming r rate of growth.
Dr. Buckley is a graduate of Harvard University, and holds a
M.B.A. and Ph.D. from N. Y. U., as well as being a member of To solve for a, it will be necessary to use the follow-
The New York Society of Security Analysts. ing formula:
MARCH-APRIL 1960 19

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 r-(n- M) (r--1) . vY The actual 1958 net incomeof InternationalBusiness
a= Machines Corporationwas $126,191,000. Thus, the
n
above 1949 forecastof the 1958 net earningsof Inter-
r - 1.160 (rate of growth) national Business Machines Corporationwould have
n 10 years (1939-1948) been 98.4% accurate.
M - 5.67-see above
Y - 137.3-see above
Using the same method as above, it is possible to
forecast the earnings of InternationalBusiness Ma-
1.160 - (10.00 - 5.67) (1.160 - 1) . 137.3 chines Corportaionup to 1968. Between 1949 and
a - 1958 the growthrate was 19.3%. Projectingthis for-
10
ward to 1968, using the same formula (y - arx), the
1.160 - (4.33) (.160) . 137.3 answerwould be $776,000,000, or $42.50 per share,
10
based on the shares currentlyoutstanding. This com-
pares with reportedearningsat that time of $6.93 per
1.160 - .6928 . 137.3 sharein 1958.
a -

10 It should be stressedthat this method of forecasting

earningsshouldbe used with caution. It is basedon the
.467 . 137.3
a= rateof growthin the past 10 years, which might not be
10.00 sustained. However,the approachis useful in compar-
63.98 ing past growth rates to currentmarketprices. Also,
a - _. the 1968 earningsmight be of interestwhen compared
10 with prices at the end of 1959. For example,it is well
a - 6.40 known that FirestoneTire and Rubber Companyand
GoodyearTire and RubberCompanyare growthcom-
Solving: Y arx panies. The following tabulation,however, will show
Y (6.40) (1.160)20 that Goodyearhas been growingat a 11.0% rate per
Y (log of 6.40) plus (log 1.160) X 20 annum, comparedwith 8.5% for Firestone. Further,
Y 0.8061 plus (.0644) x 20 Goodyearat the end of 1959 was selling6.0 times esti-
Y 0.8061 plus 1.2888 mated 1968 earnings, compared with 7.8 times for
Y 2.0941 Firestone. In selecting the purchase of the stock of
Antilog of above = 124.2 (or $124,200,000). Goodyear,in preferenceto Firestone,this factor should

Table III
Growth Rate and 1968 Earnings of Selected Companies

Earnied Per Share

12/31/59
Growth Rate Actual Estimated 12/31/59 Price divided by
(1949-1958) 1958 1968 Price 1968Est. Earnings

I.B.M. 19.3% $6.93' $42.501 438 10.3

Chemicals
Dow - -6.3% 2.392 4.00 98 24.5
DuPont - -6.8 7.25 18.13 264 14.6
Eastman Kodak - -9.7 2.57 7.42 107 14.4
Drugs
Merck3 -- 8.2% 2.53 5.25 80 15.2
Pfizer - -12.1 1.34 5.21 33 6.3
Sterling Drug - -6.3 2.42 4.38 52 11.9
Natural Gas
American Natural Gas -- 13.8% 4.441 17.24' 58 3.4
Columbia Natural Gas -- 13.9 1.44 5.40 20 3.7
Oklahoma Natural Gas -- 6.9 2.16 4.93 26 5.3
Public Utility-Holding
American Electric 9.5% 2.30 6.29 48 7.6
Southern Co. - 10.0 1.81 4.83 39 8.1
Texas Utilities - -14.3 2.73 12.43 75 6.0
Rubber
Firestone Tire & Rubber 8.5% 2.04' 5.881 46 7.8
B. F. Goodrich - -4.3 3.95 7.63 88 11.6
Goodyear Tire & Rubber -- 11.0 2.021 7.671 46 6.0
Steel
Bethlehem Steel - -6.3% 2.91 7.60 54 7.1
Inland Steel - -8.1 2.77 8.30 46 5.6
United States Steel -- 10.3 5.13 19.88 98 5.2
'Adjusted for recent stock splits. 2Year ended May 31, 1959. 3Includes Sharp & Dohme, Inc.

20 THE FINANCIAL ANALYSTS JOURNAL

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be one of several considerations and certainly not the
sole or determining one.
A comparison of several leading issues in selected
industries is shown in Table III.
From Table Ill it might be noted that the chemical
companies, which are often cited as examples of growth
companies, have shown a much slower growth rate
than, for example, several of the steel, rubber, drug,
and public utility holding companies. Also the price-
1968 earnings ratios of the chemical companies are
higher than almost all of other companies shown. Of
the three chemical companies listed, Eastman Kodak
seems to be the most attractive. Based on the rate of
earnings growth and price-estimated 1968 earnings, the
natural gas companies seem to be the most undervalued.
However, since these companies are regulated, and have
limited energy reserves (from a long-term standpoint),
they are not as attractive as their earnings growth might
indicate. This, of course, is not so true of the public
utility holding companies, which, at present prices, seem
to have a considerable amount of growth potential.
The Beloit Seminar
(Continued from Page 3)
Beloit Seminar (held at Beloit College, in association
with the University of Chicago) combines both an op-
portunity to return to the "halls of ivy", thus curing
any incipient fixations, and the opportunity to peer into
the future "as far as the human eye can see". This
most desirable state of affairs is the result of blending a
splendid program, an excellent faculty, and an ideal
location, with a student body consisting of 100 Senior
Analysts, whose background, achievements, and capa-
bilities permit them to contribute importantly to the
discussions.
"Beloit" is a rewarding experience to attending Ana-
lysts. This is evidenced by the over-all ratings of good
to excellent given the seminar by those attending in
each of the last four years. Moreover, a review of the
comments by individual seminarians clearly indicates
that the great majority felt that the formal program was
most useful in presenting a broad over-all picture of the
economy; in developing methods of analyzing the key
factors affecting monetary policy; developing methods
for analyzing, comparing and projecting cash flow as
well as earning power; and in suggesting yardsticks use-
ful in measuring quality of earnings. In addition, it may
be noted that the informal discussion periods often con-
tributed importantly to the crystallization of current
thinking on both the general market and individual
security issues. These discussions also made for closer
acquaintances and better understanding of mutual prob-
lems and individual points of view. All this, without
constant interruptions of telephones!
The week of August 21 to August 27, 1960, will
MARCH-APRIL 1960
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The HelenSladeLectures
The services of the outstanding Financial Analysts
in Wall Street have been obtained by Co-Chairmen
Lancaster M. Greene and Henry Slade Sanders for a
series of lectures at The New School, 66 West 12th
Street. The speakers are giving their services gratui-
tously in memory of Helen Slade Sanders.
In inaugurating the series of lectures in February,
Pierre R. Bretey, the editor of The Financial Analysts
Journal, speaking as the representative of all Analysts,
paid tribute to Helen Slade. Believing that this tribute
is of general interest, his remarks, are herewith repro-
duced:
For the second successive year, I have the distinct
honor of being the first of my many numerous and dis-
tinguished colleagues who are to appear on this podium
each paying his tribute to a most lovable and most
dynamic personality, the late Helen Slade Sanders. It
is peculiarly fitting that I should be the spokesman for
the Analysts in remembering Helen, having been closely
associated with her during the rapid growth of the New
York Society of Security Analysts from its humble be-
ginnings less than a quarter of a century ago, to a
present position of both influence and affluence, and
during the period of development of her pride and joy,
The Financial Analysts Journal, from a little known and
relatively insignificant publication, to one designated by
the Harvard School of Business as compulsory reading
for the serious student of business and financial affairs.
Helen Slades' major interests were not solely limited
to those of the analytical profession and its official pub-
lication. She fought with zeal and with righteous indig-
nation against a shocking industry practice-still all too
prevalent today-of considering men beyond the age of
45 as no longer employable in the face of their having
much to contribute to industry because of their rich
business experience. Before too long, we feel confident
that the cause for which she raised her powerful voice,
will find a practical solution. Within the short span of
a decade-and the years seem to speed by at accelerat-
ing rate - few of those participating in this series of
lectures will be actively engaged in their profession. It
is the hope of those who have been closely associated
with Helen Slade that The New School will continue to
cooperate with leaders in the New York Society of
Security Analysts, and with leading members of the
financial community, to continue this series of lectures
to perpetuate the memory of one to whom we all owe
so much.
again present to 100 Senior Analysts the opportunity
to combine the past with the future, and to reap the
benefits outlined in the foregoing paragraphs. The
forthcoming brochure, to be mailed to members of all
constituent societies, will present this opportunity to
you. It will be up to you to take advantage of it!
21