Implied Growth Rate

What mistake might you make when replicating someone else’s portfolio?

There’s a strong temptation to buy a stock that’s in a famous investor’s portfolio. Why not? Bill Ackman or Warren Buffett have vast experience, access to an ocean of resources for making the right decisions, and (let’s face it) there’s a high chance they might possess insider information.

The thing is, buying a stock is one thing, but buying it at the right price is another. The key isn’t that Apple’s stake is large in Berkshire Hathaway’s portfolio but when and at what price Buffett made the decision to buy it.

On the other hand, we might think that just because a famous investor isn’t selling a given stock right now, it implies positive expectations, and often, that’s the case. However, the problem is that experienced investors make long-term decisions.

For them, only two things matter: what they paid today and what it will be worth 5, 10, or 50 years from now. Along the way, though, a stock could be either undervalued or overvalued relative to its fair value (more often overvalued than undervalued).

So, if we decide to replicate someone else’s portfolio without doing in-depth analysis, we should pay attention to how prices have moved since that investor bought the stock.

Personally, the key parameter I look at is the Implied Growth Rate, which the market associates with a specific stock. Based on the company’s normalized earnings, return on invested capital, and risk-adjusted discount rate, we can conclude what long-term growth the stock must have to justify today’s price.

The formula is adapted from the book: Value: The 4 Cornerstones of Corporate Finance by McKinsey & Co., T. Koller, R. Dobbs, B. Huyett.

This formula can be applied easily in a one-page Excel sheet.