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Decide What to Pay for Growth Stocks

by Amy Buttell / June 13th, 2011

For dedicated growth stock investors, identifying superior growth companies is the first part of successful investing. The second part is figuring out an appropriate price to pay for those top-notch growth stories. The dot-com bust taught us that the sky is not the limit when it comes to paying for growth companies. Consider Cisco, which today trades at about $20. Cisco at $80 a share in March 2000 was not a bargain, even though the stock had been rising for several years, multiplying in value eight times between 1997 and the height of that bull market. By 2002, Cisco hit a five-year low of less than $10. Obviously, those who purchased the stock in early 2000 and held all the way down lost a lot of money. What did they do wrong? How can you tell when Cisco, or any other company, is a good value? By using tools, including a company's past sales and earnings growth rate and assessing its P/E (price to earnings) ratios, you can arrive at a reasonable valuation for a company.

Growth rates

The first piece of the valuation puzzle is past growth rates. For a company to get your attention it needs a consistent record of growth in earnings and sales during at least the past five years—10 years is even better. Don't bother with a company that grows in fits and starts or that has just come to market. There are too many strong growth companies in the marketplace to invest your hard-earned cash in, so why settle for anything less than the best? Although past performance is not a guarantee of future results, strong companies with superior management are more likely to deliver more of the same in the future than their weaker competitors. Think about how a company could further its growth. Will it introduce new products? Is it planning to acquire complementary businesses? Can it penetrate new markets or muscle market share off its competitors? Is the company likely to grow at the same pace in the future as it has in the past? High-growth companies eventually must slow down as they grow larger, so you can't expect spectacular, double-digit growth rates to persist forever.

Projecting future growth rates

Analyze a company's past sales and earnings growth rates. Perhaps they won't continue at such a high rate in the future, but they probably will be higher than their competitors and not too far below what they have been in the past.
If some high P/Es are distorted by an unusual event, it is wise to exclude them.
Companies of different sizes grow at different growth rates. Small- and medium-sized companies tend to grow faster than 12% to 15%, sometimes even more than 20% a year. Larger companies with more mature businesses tend to grow more slowly, in the range of 8% to 12%. You can cross-check your estimates with other sources. Independent investment analyst firms such as Value Line follow thousands of companies, and their analyses are available in most public libraries as well as online. Stock analysts offer earnings projections that are available on a number of publicly available websites including Zacks and Yahoo! Finance. Keep in mind that analysts, whether employed by an independent provider or a brokerage firm, tend to be optimistic. Also remember that sales fuel earnings, and that a company can't continue to grow earnings faster than sales indefinitely. So it's wise to keep your earnings estimates in line with your sales estimates.

Bringing in P/Es

We looked at price to earnings (P/E) ratios earlier. Many consistent growth companies exhibit a consistent range of P/E ratios over a number of years. This range is known as a company's "signature P/E." You can find that range by averaging P/Es over a number of years. It's ideal to include 10 years of high and low P/E ratios in your calculations to arrive at average or signature high and low P/Es. If some high P/Es are distorted by an unusual event, such as the dot-com bubble, it is wise to exclude them. Remember our example of Cisco—it's not likely that even the best growth story could sustain an average high P/E in excess of 100 or even in excess of 30.

The bottom line

So how do you get from growth rates to P/Es to figuring out a price you should pay for a stock? It's not that hard. Here's an example: Say that ABC Company is an attractive growth company. During the past 10 years, sales have increased at an average rate of 24% a year, while earnings have gone up at an average rate of 25%. Knowing that it is unlikely that a company can sustain such growth over the long term, we'll project that ABC Company will grow its sales and earnings at 15% over the next five years.
Companies of different sizes grow at different growth rates.
With current earnings at $1.52 a year, that means we're estimating that ABC Company will earn $3.10 five years from now. You obtain that figure by multiplying each year of earnings per share (EPS) by 15% to get the next year's figure. Now we bring in the P/E ratios. Fortunately, ABC Company's past P/E ratios aren't out of line for a strong growth company. The average high P/E ratio is 28 and the average low P/E ratio is 16. By multiplying the estimated high EPS ($3.10) by the average high P/E (28) we get an estimated future high price of $86.80. This is the highest price that we think ABC Company will sell for during the next five years. By multiplying the company's current EPS ($1.77)—which, because this is a growth company, is the lowest we think EPS will be during the next five years—by the estimated low P/E (16), we get the estimated low price of $28.32. This is the lowest price we think ABC Company will sell for during the next five years. So we have a price range of $28.32 on the low side to $86.80 on the high side. We now can divide this range into three zones. Starting with the low price, the first 25% is the buy zone and where we hope the stock's current price is. The middle 50% is the hold or maybe zone. The upper 25% is the sell zone. Thus, in this example, there's a difference of $58.48 between the low and high potential prices. Twenty-five percent of $58.48 is $14.62. If we add $14.62 to the low price of $28.32, we come up with a buy zone that extends to $42.94. So if we pay no more than $42.94 a share for this stock, we project that we can double our money in this company during the next five years.
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This article was originally published by BetterInvesting. Since 1951, BetterInvesting has helped more than five million people become better, more informed investors. BetterInvesting helps its members build wealth through educational webinars, Web-based mutual fund and stock tools, in-person learning events, publications, an active online community, and software. For more information, visit the website or call 877-275-6242. Neither CUNA nor the author of this article is a registered investment adviser. Readers should seek independent professional advice before making investment decisions.
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