Millions of investors ply their skills in the market each year with the hopes of picking a winner – that diamond-in-the-rough company that far exceeds everyone’s expectations. While the historical growth of the stock market may very well hover around 10 percent (when you look back 40 or more years), the year-to-year changes in the prices of stocks vary significantly. For those who fail to accurately predict a downturn in the economy or stock market, the financial losses can be staggering. But for those precious few whose hearts seem to beat in tune with the stock market, the profits can be limitless. A number of investment strategies for stocks currently exist, and one of the most popular is the growth strategy.
Most investors have two things in common: they are all trying to make the largest profit in the shortest amount of time; and they are all trying to do so by predicting that the future prices of the stocks they purchase today will be higher – the higher the better! Those with more patience and time to invest can easily choose the low-risk path of buy and hold stock purchasing – basically, buy stocks at the lowest prices possible today and hold onto them until a significant return can be obtained in the future – at least 1 or more years down the road. Buying stocks using this strategy is fairly safe, but the growth tends to be lower than can be obtained by using some other methods, such as the growth strategy.
Fundamentals of Growth Strategy
Investors who employ the growth strategy are basically looking at one thing: What is this company’s potential for future earnings? The underlying assumption behind the growth investment strategy for stocks is that increased earnings will lead to higher stock valuations. In turn, this should also bring about higher dividends which mean higher revenue streams and larger capital gains when the stocks are liquidated. While current or past earnings are indicators, they do not necessarily tell the entire tale as far as the growth strategy is concerned. Other factors to be considered when using this strategy to make stock purchase decisions are annual growth, overall revenue, and earnings per share.
Investors always want to know what the future holds and one of the best indicators of the potential of a company is their previous earnings. The overall sales, or gross revenue, of a business are not equal to their earnings. Instead, earnings are determined by taking the gross revenue and subtracting the costs associated with selling the products, operating expenses including labor costs, and any and all applicable taxes. While earnings may in fact be the largest single factor in determining the prices of stocks, they are not necessarily the best indicators of potential growth.
It is often the case that many smaller businesses trying to make a breakthrough will invest more to secure larger future profits in the future at the expense of current profits. These companies will often have stocks that are under valued and perfectly positioned to see a huge surge in growth, sales, and overall profits in the near future. Growth investors love companies such as these and will gladly seek out opportunities to add such stocks to their portfolio. The trick is to catch these companies while their stock prices are still low but they are just on the verge of making a major breakthrough in sales and market presence.
Knowing the earnings of a company is important to a growth investor because they can be used to calculate the price/earning ratio, or P/E ratio. When looking through the business section of a newspaper, you may notice that some companies do not have a P/E ratio. This is because they were not profitable the previous year and therefore will not have any earnings – instead they suffered losses.
The P/E ratio of stocks is important for growth investors because it is a good indicator of how much the market is willing to pay for a certain rate of growth. Those companies with a higher P/E ratio are those that investors are willing to take greater risks with. The P/E ratio is calculated as follows:
P/E = Market value of company / After-tax earnings
So what does this ratio tell the average growth investor when trying to decide which stocks to invest in? Well, let’s say that the market value of a business was valued on a per share basis at $20 each. If the after-tax earnings amounted to only $2 per share, then the P/E ratio would be 10. Is that a good or a bad thing?
Companies with a higher P/E ratio have a relatively high market valuation with relatively low earnings. Therefore, they are considered to be greater risks than those companies whose market value is more in line with earnings – or those with a lower P/E value. Such businesses which have high P/E ratios have high expectations placed upon them and it is therefore easy to buy-into a company and pay relatively high prices for the stock only to see it plummet once earnings are reported the following quarter.
P/E ratios are especially useful for growth investors who need to compare companies from the same industry. In more established industries, the P/E ratio will be more of a constant and newer companies with especially high P/E ratios should be treated with caution. In other words, the market value of the company should ideally be tied to earnings. While companies with lower earnings may be poised for a breakthrough in the market, analyzing the P/E ratios of similar companies from the same industry will nonetheless help when making stock purchase decisions.
Choosing Growth Stocks
So how does one go about identifying and selecting these companies? Are growth investors only to search out small companies with poor earnings in order to identify those businesses on the verge of a breakthrough? While some growth companies are in fact identified in this manner, there is an easier way to find growth stocks: by dividing the price per share by the book value per share. The price per share figure is simple enough to find: it is the number listed in the paper Monday through Friday with the closing prices of stocks listed on various exchanges. The book value per share, however, is a little tougher to figure out.
The book value per share is calculated by taking the total stockholder equity and subtracting the preferred stock that has been issued. This number is then divided by the common shares which are still outstanding. The result is the book value per share of the company. A comparison of the book value per share with the market value can help in determining if a stock is under or over valued. Growth companies will tend to have stock that is under valued as they tend to have greater capital expenditures and debt loads.
If you were to take the S&P 500 Index and take each company’s per share price and divide it by the book value per share, then you would end up with a new ratio. Then, if you ranked those companies by this new ratio with the larger numbers being first on the list, you would then be able to identify growth companies. Those companies in the top third of the list would be considered growth companies. However, this is not an exact science but it is a helpful tool when considering stock investment options favoring growth companies.
Growth companies will typically be newer companies. They may be large-cap investments but the tendency is for them to be small (less than $1 billion in sales) or mid-cap (company sales between $1 and $10 billion) investments. However, the common variable is that the companies have a higher-than average expectation of outperforming the rest of the market. They tend to command a higher per share price for stock than older, more established companies like General Motors. It is also true that growth companies, being younger, also tend to have less pension/benefits liabilities than companies like GM and therefore tend to be more profitable, which in turn, of course, tends to send stock prices higher. This is the reason why growth stocks are so coveted and why people devote themselves to finding formulas that can help identify them sooner than anyone else.
Growth companies will also tend to have, as mentioned earlier, higher P/E ratios. The high expectations placed on such companies are occasionally not met and the resulting crash in stock prices is precisely what makes them so risky. Intel is a perfect example of a growth company which still has a very bright future but which no longer seems to meeting the high demands of its investors.
Since its peak in 2000, Intel has failed to move beyond half of that magical peak in over half a decade. Once a growth company fails to meet the high expectations of investors, a more realistic and sustainable per share price will settle in for the stock. Since Intel has been hovering at around half of its former peak in 2000 for over five years, two things are possible: either the company is now correctly valued and was grossly overrated in the past or; the company is currently under valued and poised for a strong rebound in the near future. In the first case, Intel is still a growth stock but with less potential than in years past. In the latter, Intel is a value stock and should be purchased as it will probably outperform expectations at some point in the future and thus be a profitable investment.