As the name suggests, growth stocks are companies whose earnings are growing at an above-average rate compared to the broader market. These companies usually command much higher valuations due to the positive sentiment surrounding the company. However, despite the higher valuations, growth companies can still deliver great long-term returns if they can fulfil or even exceed their potential.
In this article, I want to discuss where and how you can find growth stocks and what valuation metrics investors should look at when analysing such stocks.
Look for high-growth industries
Perhaps the best place to look for growth stocks are in industries or sectors that are on the rise. For instance, software as a service (SaaS) companies have been profiting from a shift away from owning your own software to purchasing it as a service through subscription plans. This has resulted in companies such as Paycom, Salesforce, DocuSign and others growing at double-digit rates.
Using this top-down approach, we can focus on fast-growing industries and from there, single out stocks that are worth a closer look.
Historical growth as an indicator
The idealist will say that the future will not always mirror the past. That is true, but historical growth is a good indicator of how well the company has fared and can be a good predictor of future success. This is especially true for companies that have maintained solid growth over a long period.
This could indicate that the management is capable, can negotiate challenges and can find areas to expand. It could also mean that the industry has shown consistent growth for a long time, which also bodes well for the future.
However, investors must be wary of companies that have shown good growth only for a short amount of time. This kind of growth may not be sustainable, and extrapolating or expecting similar growth would be futile.
Look for growth catalysts and sustainability
Besides historical growth rates, investors should also look at what visible catalysts lie ahead. They can include new growth opportunities that the company can develop in the future. Moreover, sustainability of growth is key. What has fueled past growth and will it continue to persist in the foreseeable future?
The worst thing that you could do when investing in growth stocks is buying a growth company for an unreasonable price.
Warren Buffett said in his 1992 shareholder letter:
“…[T]he two approaches [growth and value investing] are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”
As the Oracle of Omaha says, even when investing in growth stocks, it is important to ensure you are paying the right amount for it.
A prime example of when stock valuations far outpaced earnings potential was in the dot.com boom of 1999. Back then, stock valuations had grown disproportionately to earnings and resulted in one of the biggest crashes to date.
As a lesson from that, investors need to be aware that even the fastest growing companies should only be bought at reasonable prices.
Using Peter Lynch’s metric of PEG
So, how then do we value growth companies when traditional metrics like price-to-earnings multiples make little sense? Legendary investor, Peter Lynch, prescribed using the price-to-earnings growth ratio. This is calculated by dividing the price-to-earnings multiple by the forecasted growth rate.
Peter Lynch recommended only going for stocks that had a price-to-earnings growth rate of below one. However, if the company’s growth rate is very high and is expected to grow for a reasonable amount of time, then a PEG ratio slightly higher than one might still be warranted.
The Foolish bottom line
Investing in growth stocks is a great way to make money in the market. A company’s share price tends to mirror its performance. Therefore, if it can live up to its expectations and continue to deliver sustainable growth, investors will be willing to pay more for a stake in the company, in turn, pushing its share price up.
However, be warned that there are also risks involved with growth companies. Because they usually command a significant premium to more mature, slower growth companies, if the growth company is unable to fulfil expectations, its share price can suddenly tank. Investors, therefore, need to do sufficient due diligence and ensure that their portfolio is sufficiently diversified when dealing with such stocks.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Jeremy Chia doesn’t own shares in any companies mentioned. The Motley Fool Singapore has a recommendation on Paycom, Salesforce and DocuSign.