Within the equity investing community, there is a relatively clear definition of two different types of sought-after stocks. There are the traditional value stocks that pay out a consistent dividend and are priced based on their fundamentals. On the other side of the spectrum, there are growth stocks. Stocks that do not pay out a dividend and reinvest all their earnings back into the company to help fuel growth.
Growth stocks are frequently valued at high (and in 2021 sometimes extreme) market caps relative to their fundamentals. Given the increased hype from Wall Street and record-high levels of retail trading fueling the next possible bubble, is it even possible to find a Growth Stock worth purchasing? There may still be a few opportunities out there, but they will take some digging to find.
Finding value in growth stocks is different than looking at traditional fundamentals. Growth stocks trading at high P/E ratios can still be undervalued. Since we want to factor in growth prospects, the current earnings and balance sheet will not tell the full story. So, how can you identify if you are getting a good deal?
1. PEG Ratio
The PEG Ratio made famous by Peter Lynch takes the P/E ratio one step further and factors in expected growth. The PEG ratio can be calculated as follows:
PEG = ( Price / Earnings Per Share ) / EPS Annual Expected Growth Rate
Since the stock market is priced on future earnings, the PEG ratio displays if the current value of the equity is accurately priced. Even when a company has a very high value compared to its core fundamentals if the growth rate is high enough it can still be a bargain. A company with a PEG ratio of less than 1 is considered undervalued.
We can look at two hypothetical companies and value them based on the PEG ratio.
- Company A
- Price: $50
- Earnings: $4
- Expected Growth Rate: 10%
- PEG Company A = ( 50 / 4 ) / 10 = 1.25
- Company B
- Price: $50
- Earnings: $1
- Expected Growth Rate: 100%
- PEG Company B = ( 50 / 1 ) / 100 = 0.5
If we only look at the P/E value of Company B, the firm looks overvalued. A P/E of 50 is much higher than many investors would care to buy into. But using the PEG ratio and factoring in the extremely high expected growth rate, the ratio signals that the firm is undervalued.
Company A has a modest P/E of 12.5, but a PEG that is higher than 1. Though a PEG value of 1.25 is not very high, Company B is “cheaper” than Company A when looking at the PEG ratio.
The PEG ratio is only one metric, and companies should not be valued strictly on one data point. A low PEG ratio should be investigated further as it could uncover an opportunity to invest in an undervalued firm.
2. Comparable Company Analysis
Comparable Analysis is looking at a firm and comparing its valuation to its competitors or similar firms. The thought here is that companies in the same sector or a similar type of business should have the same valuation methodology. Five separate semiconductor companies should have similar fundamental metrics if they share the same expectations.
Value is found here when comparing the different organizations and we see fundamental metrics of one firm that is lower than the others. These values can still be high compared to other industries, but if a firm seems to be valued at a discount compared to its peers it is worth looking into. Let’s take a look at those five semiconductor stocks in an example below:
- Company A
- P/E: 41
- P/B: 5
- Company B
- P/E: 37
- P/B: 6.4
- Company C
- P/E: 24
- P/B: 2.3
- Company D
- P/E: 45
- P/B: 7.3
- Company E
- P/E: 39
- P/B: 4.5
What doesn’t fit? Company C has almost half the P/E value as its competitors and less than half the P/B value of most of them as well. When comparing Company C to a bank, it may seem overvalued, but when we set the firm next to its peers a different story is told. Based on this high-level Comparative Analysis it is worth looking into Company C further.
Conducting a comparative analysis can go much deeper than looking at high-level fundamentals. Comparing a firm to its peers in all aspects can be a way to dig up the value that might otherwise be hidden.
3. Related Acquisition Value
On November 10th, 2020 Slack Technologies had a market value of $13.4 Billion. The fundamentals would tell that Slack is extremely overvalued, as Slack has not even broken $250 million in quarterly revenue. Why would anyone buy-in at such a high valuation? 15 days later Salesforce announced that it will purchase Slack for $27.7 billion and the stock closed 68% higher than it did on November 10th.
Identifying acquisitions of similar companies could have foretold that Slack was undervalued at the current market price. Related acquisitions tell what acquiring companies bought firms for in the past, and what a firm’s valuation is based on those acquisitions.
With growth companies, such as our example with Slack, acquisition prices are often much higher than traditional fundamental valuations. The acquiring firm sees the future potential in that business or how the firm it is about to acquire could complement its current offerings. After all, these acquiring firms are the experts in their field and may be able to see opportunities that retail investors lack sight of.
When looking for value in growth stocks, see if any of its peers were recently acquired, or any acquisitions have been announced in the firm’s industry. Cross-reference how much the peer firm was acquired relative to its growth projections, fundamental metrics, and standing in the market. Compare that to the firm you are looking into. If there is a significant gap in the current price to the price it could be acquired for, it may be undervalued.
4. Underestimated Future Opportunities
The market prices stocks based on future expectations, but analysts, as well as retail investors, don’t know the answers to some of the more common Wall Street Questions:
How many cars will Tesla sell in five years?
What will Apple’s earnings be next year?
How many new subscribers can Netflix have in 2 years?
The market is made up of people like you and me making educated guesses to what the future holds. Sometimes, new technologies or products are overlooked as people don’t have the capacity to imagine their future potential. Who would have known how big PCs would be before they existed, or that everyone would have a smartphone when landlines were the main way of communication?
Being able to spot the potential of the next Netflix is a daunting task, but finding undervalued opportunities can be easier. It is as simple as finding value where others don’t see it.
Try using your own expertise to spot undervalued firms. An employee will sometimes have more insight into an industry they are apart of than Wall Street analysts. This gives them knowledge into what firms have the potential for future growth above what the market is currently pricing them. Look into firms within your industry and see what opportunities you might spy.
Not employed in one of the S&P’s sectors? Look at companies that have a history of outperforming analyst expectations. When a company consistently outperforms its expectations there may be an underlying value that the market missed. Garmin is a good example of outperforming expectations (full disclosure I am a shareholder) per the graph above. Stocks like this tend to deliver consistent performance.
Value in Growth Stocks can be hidden in the most unusual places, even in an “overpriced” market. Take a deeper look at growth stocks that are on your radar to see if you can find hidden value.
Not interested in stocks? Try looking at a few alternative investment ideas over at Have Your Dollars Make Sense.
Use any other tips and tricks? Leave them in the comments below!
