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All trading basics

Growth at the right Price

The ideal stock, say famous investors such as Warren Buffett or Peter Lynch, involves a company with profit growth above its industry average and below-average valuation. When you buy shares, you are investing in the growth outlook of a firm. Share prices essentially reflect investors' expectations regarding a company's future profits.

How, then, can we know if we are paying the right price for a company's future growth? There are many possible answers to this question. Some are very complex, while others are quite simple. The most basic one revolves around the notion that a share is a bargain when its price/earnings (P/E) ratio is lower than the growth rate of its profits.

Let's say a share in ABC Corp. is trading at 12 times its profits for the last four quarters, with analysts forecasting, on average, 20% annual profit growth for the next five years. Its P/E ratio would thus stand at just 60% of its growth rate (12/20). Some hunters of "growth at the right price" would go as far as saying that true bargains are stocks whose forecast annual profit growth is double its P/E multiple (10/20 or less).

Stocks with this characteristic are very rare. Scarcely 4% of companies listed on U.S. or Canadian exchanges meet this requirement. A quick search using the Yahoo Finance stock selector showed me that, on January 15, 2004, there were only 401 companies listed on U.S. exchanges with P/E ratios below their forecast profit growth.

Do your own research. Use the globeinvestor.com stock selector, or go to lesaffaires.com, and you'll see that scarcely 40 to 50 Canadian companies meet this condition.

While a stock's P/E multiple is a relatively objective financial statistic, the contrary applies to information on profit growth forecasts, which depend on the judgment of financial analysts. Is the number of financial analysts issuing forecasts on the future profits of a given company an important variable to consider in setting a strategy aiming for growth at the right price? It appears so.

In a series of academic articles published in the 1980s, Professors AvnerArbel and Paul Strebel showed that the companies least exposed to examination by analysts were those that provided the best yields, regardless of their size. I would suggest, however, that you focus only on companies followed by a minimum of four financial analysts.

In a context where we keep hearing that stocks are trading at historically high levels, investors who take the trouble to do a minimum of research will always manage to discover growth shares selling at prices that are more than interesting.