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Investing in growth stocks can be a great way of building wealth over time, but they can also be risky. High valuation multiples can mean small disruptions have big impacts.
Anyone getting started with investing needs to think about how to analyse growth shares. The good news is that they aren’t so different to any other stocks.
Growth and value
All investors should be interested in how much money a business is going to make in the future. But the main difference is when the profits are going to come in.
Value stocks are shares in companies where the earnings currently (or in the very near future) justify the current share price. With growth stocks, these are further in the future.
That means there’s a certain risk with growth stocks. If earnings don’t materialise as expected, an investment can turn out badly, leaving someone with an overpriced stock.
As a result, the key question for growth investors is how long a company can keep increasing its earnings. And there are two parts to this question.
The first is how fast a company can expand into new product lines, locations, or geographies. The second is what sort of growth it can generate once it has reached this point.
These aren’t always straightforward questions. But let’s have a look at an example to illustrate the points in action.
A top FTSE 100 stock
Halma (LSE:HLMA) is one of the best-performing FTSE 100 growth stocks of the last 10 years. It’s a collection of specialist technology businesses focused on safety.
A major source of growth for the company has been acquiring other businesses. But it can’t do this indefinitely, so investors need to think about how long this can last.
Halma is big by UK standards, but it should be able to use acquisitions to boost its growth for some time. The risk, however, is that the firm might overpay for a business.
The second question is what happens when these opportunities become more scarce. And this is why investors pay close attention to a metric called ‘organic revenue growth’.
This measures how much revenue is increasing in the firm’s existing businesses. And this has consistently been above 10% per year since 2020, which is very impressive.
Based on the firm’s adjusted metrics, Halma shares trade at a price-to-earnings (P/E) ratio of 34. That’s high by UK standards, but investors have to work out whether or not it’s justified.
Investing conclusions
Halma shares look expensive, but there’s reason to believe they might not be. If the company keeps growing at 10% a year, the P/E ratio will fall to 20 within five years.
That’s the organic growth rate of the last five years. And while there are no guarantees, the calculation doesn’t include anything for expanding margins or acquisitions.
Given this, I think the estimate might be reasonably conservative. So investors might well want to take a closer look at what seems to be an expensive stock.
Ultimately, all investing is about a company’s future profits. But growth investors typically look to be patient in exchange for bigger rewards further down the line.
Investors need to be wary of companies that can’t live up to their billings. But when things go well, growth stocks can create huge wealth over time.
