Growth Stocks
One way to determine sustainable growth for a stock is a measurement called “return on invested capital.” This measures whether companies are finding lucrative projects that can power future growth. Today, numbers in the 13-16% are considered ordinary, while those above 30% are excellent (e.g., Apple, Philip Morris International, and Priceline.com both have returns on invested capital of more than 40% as of March 2012).
Determining whether growth stocks are reasonably priced is difficult since P/E ratios alone do not show growth rates and complex financial models rely on making assumptions far into the future. A simple alternative is “relative” valuation, which involves comparing companies on a combination of metrics such as P/E ratios and long-term earnings-growth forecasts.
Advisors should keep in mind that with fast growth comes the possibility of a quick loss if that growth slows. P/E ratios in the high teens or even low 20s do not significantly increase an investor’s risk level; however, once you get above 25, one should have a “very clear understanding of the long-term potential for the business.”