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Investing in growth stocks can be a great way to build wealth over time, but it can also be risky. A high measurement frequency can mean that a small disturbance has a large impact.
Anyone new to investing needs to think about how to analyze growth stocks. The good news is that they are not much different from any other stocks.
Growth and value
All investors should be interested in how much money a business will make in the future. But the big difference is where the profit will come.
Stocks are the shares of companies where current earnings (or in the near future) justify the current price. With stock growth, these will continue in the future.
That means there is some risk with stock growth. If the returns do not materialize as expected, the investment may turn out to be negative, leaving someone with an overvalued stock.
As a result, the key question for growth investors is how long the company can continue to grow earnings. And there are two parts to this question.
The first is how quickly the company can expand into new product lines, areas, or territories. The second is what kind of growth it can produce once it reaches this point.
These are not always straightforward questions. But let’s look at an example to illustrate the practical points.
The highest value of the FTSE 100
Halma (LSE:HLMA) is one of the best performers FTSE 100 stock growth for the past 10 years. A collection of security-focused technology businesses.
A major source of company growth is acquiring other businesses. But it cannot do this forever, so investors must think about how long this can take.
Halma is big by UK standards, but should be able to use acquisitions to boost its growth for some time. The risk, however, is that the company may overpay for the business.
The second question is what happens when these opportunities become rare. And that’s why investors pay so much attention to a metric called ‘income growth’.
This measures how much revenue is growing in the company’s existing businesses. And this has been over 10% per year since 2020, which is very impressive.
Based on the company’s adjusted metrics, Halma shares trade at a price-to-earnings (P/E) ratio of 34. That’s high by UK standards, but investors should check whether it’s worth it.
Planting ends
Halma shares look expensive, but there is reason to believe they may not be. If the company continues to grow at 10% per year, the P/E ratio will drop to 20 within five years.
That is the natural growth rate of the last five years. And while there are no guarantees, the figure does not include any increase in margins or acquisitions.
Given this, I think the estimate may be reasonably conservative. So investors may want to take a closer look at what appears to be an expensive asset.
Ultimately, all investing is about the future profitability of the company. But growth investors generally seem to be holding out for big rewards on the downside.
Investors should be wary of companies that cannot meet their debts. But when things go well, growth stocks can build enormous wealth over time.
