- There are two main methods of investing
Companies that are growing rapidly are Growth Companies. The growth speed of these companies is greater than their respective companies of the same industries. Growth investing is a completely different strategy from value investing. In value investing we always tried to find the undervalued companies, we focused on valuation. In growth investing, we don’t focus on the valuation but on the rapid growth of the company.
Growth investors also buy shares of Overvalued Companies.
Those companies have fast growth (included 20% or more per annum currently and in future) in revenue, free cash flow, profit consider growth companies.
Most of the growth companies are trade on high valuation. Small and middle cap category companies mainly are growth companies.
Growth investors always look for investments in rapidly expanding industries (even entire markets) where new technologies and services are developed. On one hand, look for profits through capital appreciation—that is, the gains they’ll achieve when they sell their stock, as opposed to dividends they receive while they own it. Most growth-stock companies reinvest their earnings back into the business, rather than pay a dividend to shareholders. They tend to be small, young companies (or companies that have just started trading publicly) with excellent potential. The idea is that the company will prosper and expand, and this growth in earnings and/or revenues will eventually translate into higher stock prices in the future.
As investors seek to maximize their capital gains,
Growth investing is also known as a capital growth or a capital appreciation strategy.
Evaluating a Company’s Potential for Growth
Growth investors look at a company’s or a market’s potential for growth. There is no absolute formula for evaluating this potential; it requires a degree of individual interpretation, based on both objective and subjective factors, and judgment. Growth investors may use certain methods or criteria as a framework for their analysis, but these methods must be applied with a company’s particular situation in mind; specifically, its current position vis-a-vis its past industry performance and historical financial performance.
Growth investors look at five key factors when selecting companies that may provide capital appreciation. These include:
Strong historical earnings growth.
Companies should show a track record of strong earnings growth over the previous five to 10 years. The minimum EPS growth depends on the size of the company: for example, you might look for growth of at least 5% for companies that are larger than $4 billion, 7% for companies in the $400 million to $4 billion range and 12% for smaller companies under $400 million. The basic idea is that if the company has displayed good growth in the recent past, it’s likely to continue doing so moving forward.
Strong forward earnings growth.
An earnings announcement is an official public statement of a company’s profitability for a specific period – typically a quarter or a year. These announcements are made on specific dates during earnings season and are preceded by earnings estimates issued by equity analysts. It’s these estimates that growth investors pay close attention to as they try to determine which companies are likely to grow at above-average rates compared to the industry.
Strong profit margins.
A company’s pretax profit margin is calculated by deducting all expenses from sales (except taxes) and dividing by sales. It’s an important metric to consider because a company can have fantastic growth in sales with poor gains in earnings—which could indicate management is not controlling costs and revenues. In general, if a company exceeds its previous five-year average of pretax profit margins – as well as those of its industry—the company may be a good growth candidate.
Strong return on equity.
A company’s return on equity (ROE) measures its profitability by revealing how much profit a company generates with the money shareholders have invested.
Calculation = dividing net income / shareholder equity.
A good rule of thumb is to compare a company’s present ROE to the five-year average ROE of the company and the industry. Stable or increasing ROE indicates that management is doing a good job generating returns from shareholders’ investments and operating the business efficiently.
Strong stock performance.
In general, if a stock cannot realistically double in five years, it’s probably not a growth stock. Keep in mind, a stock’s price would double in seven years with a growth rate of just 10%. To double in five years, the growth rate must be 15% – something that’s certainly feasible for young companies in rapidly expanding industries.
Let’s take on example to understand growth investing and value investing.
For value investing
If the intrinsic value of the share is 100 and the current or actual price is 80
And the company is not a growth company therefore the maximum profit is only Rs.20 (limited profit and low risk).
For growth investing
Let say the intrinsic value of the share is Rs.100 and the current or actual value is Rs.120.
According to value investing, this is overvalued stock, but if the company is a growth company then the intrinsic value increases as the company are growing. So, the growth investor focuses on the company’s growth (unlimited profit, high risk).
Now the question is which is better?
Answer– Invest in undervalued growth companies (strategy of Warren Buffett and Peter Lunch).