Investing in growth stocks normally requires a growth premium to be paid.

The growth premium reflects the above average expected growth rates in the company’s earnings. So you better be sure that the company earnings continue to grow over time.

There are a few areas of quantitive analysis to help assess future growth prospects. 

The Wall Street Journal outlines these areas in How to Tell if a Growth Stock Can Keep on Growing.

Organic Over Acquired

“Organic” revenue growth, which comes from winning new business, is generally better for shareholders than growth fueled by acquisitions, experts say, because it tends to cost less and carry fewer risks. Management’s discussion of operations in its quarterly reports often contains clues to how much of the growth is organic.

It may be easy in the short term to buy growth. But the costs of integration and ensuring that old and new corporate components move in lockstep, can be a costly process.

Also, be aware that some companies use acquisitions to distort prior years’ performance comparisons.

Growth Over Cost Cutting

But keep in mind that any earnings growth driven by cost cutting and share repurchases might not last for long. Just as important is to look for increasing revenue, the hallmark of long-term growth.

Earnings is a function of revenues and expenses.

Revenues come from the sale of products and services. New products that are highly sought by customers indicate revenue growth. Revenues are great because they can grow forever.

But you want to see more that just sought after products. Is there a pipeline of new products that will enter the marketplace to spur continuing growth? Is there protection in place (e.g., patents, cost to produce, control over inputs, etc.) that prevent other firms from entering your market and stealing business? Are there any regulatory (e.g., reclamation costs for mines) or other potential issues (e.g., doing business with clients in a newly sanctioned country) that can impact future revenues? And so on.

Expenses, on the other hand, cannot be cut forever. If a company is experiencing earnings growth due to cost cutting, layoffs, asset sales, etc., those can only go so far. These measures will have a one-time impact on earnings, but will not generally drive future earnings growth. I say generally because lower costs may allow a company to reduce sales price which may stimulate demand. If competitors cannot match, then it may drive long term sales growth.

When assessing current growth rates, make certain you understand where the growth came from. And if it is sustainable in the future.

Return on Invested Capital

Another place to spot sustainable growth is a measure called “return on invested capital,” which is listed on some stock-quote websites. The measure shows whether companies are finding lucrative projects that can power future growth. Today, numbers in the 13% to 16% range are ordinary, while those above 30% are excellent

I would caution about following the given guidelines. Today, 13-16% may indeed be ordinary. 5 years from now, 35% (or 5%) may be ordinary. Never take a guideline as forever. Always put things in context against the circumstances at the time you are assessing. Do comparisons against the company’s history, its peer group, and the market as a whole. Never rely on the fact that someone told you once that “such and such” was the correct benchmark.

This is one area that is making me a little jittery about Apple and their dividend announcement. Granted, Apple has a pile of money under its iMattress. But, in general, companies that have excellent projects to develop will finance those through internal cash flow (or debt or equity financing).

That is why growth companies typically do not pay out dividends. They believe that their shareholders will get a better long term return by having the company reinvest its profits in new corporate ventures than by paying out dividends. And growth investors agree.

However, companies that do not have new projects in the pipeline with acceptable internal rates of return tend to pay out more money to shareholders. The idea is that the shareholder is better off with the cash, so that he or she can invest in other opportunities that may provide better returns.

When I see any company raise its dividend rates or buy back shares, it makes me wonder if long term growth prospects are dimming.

Work Forward and Backward When Analyzing Investments

Mr. Koller favors another method for telling which growth stocks are worth their prices: working backward on the math.

With any potential investment, you want to analyze from all sides. Sometimes the numbers make sense in one sense, but less so in another.

What Goes Up Can Come Down

Above all, investors should keep in mind that with fast growth comes the possibility of a swift tumble if that growth slows. P/E ratios in the high teens or even low 20s don’t increase an investor’s risk significantly, Mr. Koller says. “But once you get above 25 you’d better have a very clear understanding of the long-term potential for the business.”

More good advice. Although remember that a price-earnings (P/E) ratio of 25 may be high today. It may be reasonable (or insane) next year.

The premium paid for a growth stock is kind of like leverage. As the stock’s prospects shine, the premium may rise and enhance the company’s share price more than the base fundamentals. Part of this may be due to hype and investor excitement.

When the company fails to meet expectations, it may be punished by unhappy investors.

Consider Intuitive Surgical, the company we looked at in Growth Stock Premiums. As at March 23, 2012 it closed at USD 533.51 and its forward P/E ratio was 31.51. So expected one year future earnings are USD 16.93.

Perhaps Intuitive meets those earnings forecasts, but investors are underwhelmed and lower the growth premium to a P/E of 20. Still high, mind you. That would cause the share price to fall to USD 338.60, down 37%. Yet, in this scenario, Intuitive met its earnings projections.

Even worse if Intuitive stumbled. Say they only earned USD 14 in earnings next year. 17.3% less than expected. At a P/E of 36, that translates into a share price of only USD 441.14. Still a 17.3% decrease. But if the growth premium falls so that the P/E ratio is 20, the share price will go to only USD 280. A 47.5% reduction.

If you buy low and a growth premium starts to reflect in the P/E ratio, great. But if you pay a premium for the stock, be aware that if the company’s prospects slow, you can get hit in more than one way.

Those are a few of the common areas used to assess a company’s future growth potential.

Accounting, Finance, and Business Knowledge is Key

Investing in growth stocks can provide excellent investment potential, but it is not always easy to implement. Identifying growth stocks might be straightforward. Assessing the growth premium that must be paid and whether the company can sustain its growth rates rates is much more tricky.

As you can see in the above points, analyzing companies requires the ability to comprehend financial statements and business forecasts. It is also important to understand the business – market, products, competitors, trends, regulatory, etc. – if you wish to successfully analyze stocks.

And, yes, this applies with value investing as well.

If you want to become a better investor, spend some time in other areas of learning.

Or stick to passive investing. Where you can spread out the investment risks in a well-diversified portfolio of  identified growth (or value) stocks.

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