Growth At A Reasonable Price (GARP) – How it is Difference From Value Investing

Growth at a reasonable price (GARP) is an investment strategy that is suitable for small investors like us. How? It clubs the growth and value investing strategy to yield a hybrid outcome.

Why GARP is required if we have growth and value strategies in place? Because there is an evolving bunch of investors who want their stocks to do both.

Can value investing do both? Yes, but there is a problem. The intrinsic value estimation of a stock is done using the future growth prospects of the company. But a limitation of value investing is its dependency on mathematical models (like DCF). Not everybody is comfortable with such calculations.

Growth at a Reasonable Price (GARP) is a concept that can be used to identify a growth stock trading at a reasonable price. Though this analysis is not as deep as value stock analysis, for retail investors, it can help to shortlist good stocks.

Once the shortlisted stocks are available, an excel sheet can be used to analyze them more deeply.

Growth At A Reasonable Price (GARP) to shortlist stocks

There are three parameters based on which the GARP strategy works. The future earnings growth and low price valuations form a basis. These two parameters are then clubbed together to arrive at a GARP multiple. It is the low GARP multiple stocks that are finally considered good.

Let’s see how we can do it ourselves.

Future Growth:

For small investors like us, the way to forecast future earnings growth rates is to look into the past. We can look at their PAT and EPS numbers in unison.

Note the last 10 years’ PAT and EPS numbers of the company. Plot a line chart for both of them to get a visual trend.

To quantify the trend. We can also calculate the last 10-Yr, 7-Yr, 5-Yr, and 3-Yr growth rates, for both PAT and EPS. The Growth rate (CAGR) formula to be used for calculation is shown below.

Now, compare the PAT and EPS growth numbers.

Digging into the PAT and EPS Growth Rates

Compare the PAT and EPS growth rates. If they are growing at the same pace in all years, it is an ideal growth story.

For some stocks, the PAT growth rate will be higher than EPS growth. It is a situation that will happen only if the company has raised funds by issuing more shares. The number of shares outstanding for such companies grows with time. This in turn reduces the EPS numbers. As an investor, we want outstanding shares to remain constant or reduce in numbers (due to shares buyback).

EPS = PAT / NO OF SHARES

If PAT is growing at a negative rate, then EPS will also show a negative growth rate. Companies showing such characteristics are avoidable.

Note: You can see in the above table, our example stock’s PAT has grown at a slow pace in the last 10 years. But its EPS numbers are either negative or below PAT growth rates. For me, this is a company that is not falling in the investor-friendly range. Though there can be other factors that can fall in its favor. Only a deeper analysis will confirm it.

I use a weighted average method to forecast future earnings growth. Here is the formula:

Growth Rate = 15% * EPSG3Y + 20% * EPSG5Y + 30% * EPSG7Y + 35% * EPSG10Y

If we have a formula, why it is required to establish a trend? The trend of PAT and EPS will highlight the cause of positive or negative growth rates.

• If a positive growth rate is because of growing PAT and shares buy-back it is the most suitable scenario.
• A combination of growing PAT and constant or negligible shares-outstanding growth is also good.
• If PAT is growing but EPS is not growing, it is a case of too much share liquidation. I personally consider this occurrence as a negative indicator, highlighting non-investor-friendly management. Why? Because shares issuance is in the control of the top management. If shares are issued so rampantly that it is causing negative EPS growth, it is not serving the shareholder’s value.

Price Valuation

Once the future growth rate is established, the stock’s price analysis is comparatively simpler. We can consider only the PE ratio (Price To Earning Ratio) as the qualifying metric.

PE = Price / EPS

• The Price will be the current stock price.
• EPS will be the trailing twelve-month EPS (EPS-TTM).

What we can do more is to analyze the PE number a bit deeper. How? By establishing the PE trend and estimating a forward PE (PE of the future).

For that, we will have to calculate the PE of the last 5 or 10 years. Note the price and EPS data for a 10-Yr time period (as shown below):

Once these two data are available, calculate the PE ratio of the 10 years as tabulated above. Once the calculation is done, we can plot a line chart and establish a trend.

• The ideal case will be to see a rising PE. Here we will use a forward PE greater than the current PE (PE-TTM)
• In case of a falling trend, we will use a PE that is lower than the current PE (PE-TTM).

The above two steps have established the ‘future earning growth rate’ and ‘Forward PE’. Now, we are ready to confirm if the stock is showing the characteristics of “growth at a reasonable price (GARP)?” How to do it? By calculating the GARP multiple.

GARP Multiple (PEG Ratio)

The lower is the GARP multiple (PEG ratio) the better. If the PEG ratio is below one, the stock’s price is said to be at par with its growth rate. If the PEG ratio is below one, the stock can be said to be undervalued.

There is a difference between low pe PE stocks and GARP stocks. The stocks showing a low GARP multiple may have a high PE ratio, but their PEG will be one or below.

Conclusion

People who seek to invest in GARP stocks do so to take the benefits of both worlds.

People who practice value investing may get stuck with a stock whose price stays flat for a long time. A value stock can remain unrecognized for an extended period. Till a value stock starts to attract the attention of institutional investors, it may continue to yield low returns.

The stock of a famous fast-growing company generally trades at an expensive price level (high PE). Hence, buying such stocks may not yield good returns in times to come.

But GARP stocks create a balance between high-PE and high growth.

This is what makes Growth At A Reasonable Price (GARP) strategy suitable for small investors. It is both easy to understand and execute.

Have a happy investing.