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Growth Stock Premiums

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I have written a bit about value investing [4] lately. Mainly in the context of Warren Buffett [5] and Benjamin Graham [6], two staunch advocates of value investing.

But there is also growth investing. A slightly different approach to investment analysis.

Today we will show a little love for those who wish to acquire growth stocks [7]

Value or Growth?

I think there is opportunity in both areas. Put a gun to my head and I would choose value investing. If the gun is cocked, small cap value investing. But that is just me.

Growth investors can also do quite well.

And many investors jump between the two investment styles. Probably the best approach as economic/market circumstances that are favourable for value plays often are less so for growth. And when growth stocks are in vogue, value stocks may lag.

Ceteris paribus, I prefer value investing for long-term investing. I believe it is easier for me to identify under-valued assets than to outguess other investors on premiums paid for current growth rates and future growth projections. However, when market conditions are right, I definitely utilize a growth strategy.

The Growth Premium

It is not that difficult to identify a growth stock. Just look at prior, actual and future forecast growth rates. Both in absolute terms as well as comparative (the company, peers, market).

If a company is projecting next year earnings growth of 15% and the market is projecting only 7%, you probably have a growth stock. If the company is forecasting 20% growth, but its peers are expecting 40%, it may not be a growth stock. You always need to put your investment analysis in context.

So identifying growth stocks is not too hard.

However, in exchange for growing earnings, buyers of growth stocks must pay a premium. Evaluating this premium is the tricky part. Ah, there is always a tricky part when investing.

Is Your Growth Stock Worth the Premium?

Will the growth stock continue to grow at a rate to justify the premium paid? That is the question explored by The Wall Street Journal [8].

For example, consider Intuitive Surgical. A company cited in the linked article.

Intuitive Surgical, a maker of medical robots, is expected to increase its earnings by 33% this year.

That is tantalizing growth at a time when the broad Standard & Poor’s 500-stock index is projected to see a 9% gain in operating earnings this year, versus 15% last year and 47% in 2010.

A growth stock? Most likely. But, and there always tends to be a but.

But investors might pause before buying Intuitive when they see the price: 36 times this year’s earnings forecast, compared with 13 times for the S&P 500.

Is the 33% projected growth rate – a key driver of share price – worth paying 36 times earnings per share? Quite a premium as the average stock only trades at 13 times earnings.

That is the question. And the challenge for successful growth investors.

You must pay a premium to acquire a growth stock. So you had better make sure the company’s earnings continue to grow at a rate justifying the premium paid.

Next time, we will discuss ways to assess a company’s future growth [9] prospects.