Question

From the e-Activity and based on the growth company selected, assess why it is a growth stock and if that status is sustainable. Evaluate whether or not P/E is an effective indicator of a growth stock. Suggest an alternative.

Answer 1

Growth Stocks vs. Value Stocks

Investors are often confused about the differences between growth stocks and value stocks. The main way in which they differ is not in how they are bought and sold, nor is it how much ownership they represent in a company. Rather, the difference lies mainly in the way in which they are perceived by the market and, ultimately, the investor.

Growth stocks are associated with high-quality, successful companies whose earnings are expected to continue growing at an above-average rate relative to the market. Growth stocks generally have high price-to-earnings (P/E) ratios and high price-to-book ratios. The P/E ratio is the market value per share divided by the current year’s earnings per share. For example, if the stock is currently trading at $52 per share and its earnings over the last 12 months have been $2 per share, then its P/E ratio is 26. The price-to-book ratio is the share price divided by the book value per share. The open market often places a high value on growth stocks; therefore, growth stock investors also may see these stocks as having great worth and may be willing to pay more to own shares.

Investors who purchase growth stocks receive returns from future capital appreciation (the difference between the amount paid for a stock and its current value), rather than dividends. Although dividends are sometimes paid to shareholders of growth stocks, it has historically been more common for growth companies to reinvest retained earnings in capital projects. Recently, however, because of tax-law changes lowering the tax rate on corporate dividends, even growth companies have been offering dividends.

At times, growth stocks may be seen as expensive and overvalued, which is why some investors may prefer value stocks, which are considered undervalued by the market. Value stocks are those that tend to trade at a lower price relative to their fundamentals (including dividends, earnings, and sales). Value stocks generally have good fundamentals, but they may have fallen out of favor in the market and are considered bargain priced compared with their competitors. They may have prices that are below the stocks’ historic levels or may be associated with new companies that aren’t recognized by investors. It’s possible that these companies have been affected by a problem that raises some concerns about their long-term prospects.

Value stocks generally have low current price-to-earnings ratios and low price-to-book ratios. Investors buy these stocks in the hope that they will increase in value when the broader market recognizes their full potential, which should result in rising share prices. Thus, investors hope that if they buy these stocks at bargain prices and the stocks eventually increase in value, they could potentially make more money than if they had invested in higher-priced stocks that increased modestly in value.

Growth and value are styles of investing in stocks. Neither approach is guaranteed to provide appreciation in stock market value; both carry investment risk. The return and principal value of stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost. Investments seeking to achieve higher rates of return also involve a greater degree of risk.

Growth and value investments tend to run in cycles. Understanding the differences between them may help you decide which may be appropriate to help you pursue your specific goals. Regardless of which type of investor you are, there may be a place for both growth and value stocks in your portfolio. This strategy may help you manage risk and potentially enhance your returns over time.

Many investors pay close attention to price-earnings ratios for clues on whether a stock is overvalued or undervalued.

But that approach doesn't work for growth stocks.

The P-E ratio is a common method of valuing stocks. It is computed by dividing a company's current share price by its earnings per share over the past 12 months. The higher the ratio, the more expensive the stock is considered. So, many value-focused investors shun stocks with a P-E ratio of, say, 20 or more .

But growth-stock investors should have no problem buying a stock with a P-E ratio of even 50 or higher, as long as it meets the criteria laid out in IBD's CAN SLIM investing system.

No Correlation

That's because IBD studies of the biggest market winners over the past 50 years show no correlation between their P-E ratios and their huge run-ups. In fact, many had high P-E ratios before starting their ascents.

For example, Google's (GOOG) P-E ratio was a whopping 133 when it broke out above a 113.58 buy point in September 2004, not long after it went public. The Internet search engine went on to quadruple by January 2006, to a high of 475.11.

"The fact is, investors with a bias against what they consider to be high P-Es will miss out on some of the greatest opportunities of this or any other time," wrote IBD Chairman and founder William J. O'Neil, in "How to Make Money in Stocks."

IBD research has found that strong fundamentals and a sound chart, not P-E ratios, are far more relevant in determining whether a stock will be successful.

Google's earnings roughly doubled every quarter for six straight quarters leading up to its September 2004 breakout, and revenue growth was similarly robust. The strong, sustained earnings growth was the reason why Google traded at such a high premium. As growth slowed, so did Google's P-E Ratio, which now stands at about 20.

"The reality is, the lowest P-E usually belongs to the company with the most ghastly earnings record," O'Neil wrote.

In some mature industries where there's little innovation and competition is intense, the result is low profit margins and weak earnings growth. You'd find some low P-E ratios in those companies.

To be sure, P-E ratios can come in handy for sophisticated value investors looking to find undervalued stocks. Such investors know that a low P-E ratio doesn't always mean a stock is cheap. Rather, it can be a sign the stock has little prospect for growth.

They also know that high-growth stocks can be risky. Stocks with a high P-E ratio must meet high expectations. A disappointing quarterly earnings report can send such stocks reeling.

That's why it's important to follow IBD's CAN SLIM rules when investing in high-growth stocks.