There are only two tribes in the stock market: the value investors and the growth investors.
If investing is basically about buying low and selling high, value investors are fixated on the “buy low” part.
They’re a stingy lot. They look for assets and profits which are “going cheap”. Value investors buy cheap stuff and wait patiently for the market to price them more fairly. To find cheap stocks, they look at things like price to earnings ratios – which show the stock price relative to a year’s profits – or price to book ratios, which show how the stock price compares to the company’s assets.
Some of the most successful investors of all time are value investors. Warren Buffett famously got his start buying “cigar butt stocks” – stocks the market had no interest in, but which were still good for “a couple of puffs”.
Growth investors, on the other hand, are more fixated on the “sell high” part of the equation.
What to pay for growth
Growth investors buy stocks that are about to grow, and hope to sell them later for a profit. To work out whether a company is likely to grow, they look at the fundamentals of the underlying business.
Of course, the ability to find fast-growing companies doesn’t matter much if the growth investor overpays for them. For example Snapchat is lining up an early 2017 IPO. That company is almost certain to grow its revenues a lot over the next five years. But the price being mooted at the moment is over 20 times revenues (not earnings!) – that might be too steep a price to pay.
So in a sense everyone is a value investor – the difference being that value investors are fixated on finding value today, but growth investors are fixated on finding value tomorrow.
Value investors have an easier job finding stocks because they only have to worry about the here and now. So if a value investor sees a company with a low price to book ratio relative to similar companies, today, he knows its worth investigating.
But by necessity, growth investors have to extrapolate. That makes valuation a bit more complicated.
The growth ratio
Of course, all things being equal, a growth investor likes to see earnings growth. But all things being equal he’ll like to pay as little as possible for that growth. And all thing being equal, he’ll like to see growth that’s sustainable into the future.
That’s the issue for growth investors: finding companies that are cheap given their future earning potential.
The standard pe ratio doesn’t tell you that. A fast growing technology company might have a pe of 21, and a stodgy utility might have a pe of 12. But you can’t say, based on that comparison, that the utility is better value than the technology company. It’s not apples-to-apples.
A stock trading on a pe of 30 would send most value investors running. But if that stock can sustain 20% annual earnings growth for five years, it’ll have increased earnings 150% in that time. If it’s still trading on a pe above 20, it’ll have doubled the investor’s money.
In other words, there’s a level of earnings growth that could justify any multiple. And secondly – the sustainability of earnings growth matters a lot. One big year of, say, 40% earnings growth is worth a lot less than five steady years of 15% growth.
So how do you go about pricing a “moving target” growth stock? You’ll be happy to know there’s a number for that. It’s called the peg ratio (that’s price/earnings/growth), and adapts the value investor’s trusty pe ratio for changing, growing growth companies.
To calculate the peg ratio, you divide the trailing pe ratio (that is, the price divided by past earnings) by a forecast of earnings growth for the next five years.
A peg ratio of about 1 is considered fair, whereas a peg ratio of less than 1 is considered good value.
pe ratio / % anticipated earnings growth = peg ratio.
Let’s take the example of Facebook, a big company which is growing very quickly.
It’s currently priced at a p/e of 61. So according to the peg ratio, it’ll need to grow earnings by about 60% per year for the next five years in order to be priced fairly.
The peg ratio is useful because if clarifies thinking. You know what to aim for and what to avoid. And you know what a growth stock will need to deliver in order to be worth the price being asked for it.
Of course, that’s just the start of it. The real art is working out which companies are likely to grow their earnings. And that’s what The Penny Share Letter is for! Click here to take out a trial subscription to my latest research into fast-growing small companies.
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