NEW YORK (CNN/Money) - Stock prices follow earnings.
From time to time, investors may decide to pay greater than average prices for the earnings of a popular company -- seen in a higher price/earnings ratio. But P/Es can't increase indefinitely. Superior returns over a decade or longer depend chiefly on earnings growth.
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As a result, growth investing -- selecting companies with above-average projected earnings growth -- should be a key part of your strategy. In fact, blue-chip growth stocks should make up anywhere from 35 percent to 60 percent of the typical individual investor's portfolio.
Of investing strategies, growth is also the simplest. Historically, the S&P 500 has returned nearly 12 percent per year, on average. So if you can find a company with earnings growing faster than that, the stock should eventually outpace the market -- provided its earnings come through as expected and that the stock was reasonably priced to begin with.
The right price
What's a fair price? P/E ratios and price/cash-flow ratios are the most common measures of how expensive a stock is. A lot of factors influence P/Es, including interest rates, the company's track record, and the industry it's in. But one reliable tool is to compare a stock's P/E to its projected earnings growth.
Ideally, you don't want to buy at a P/E that's much higher than a company's growth rate. For example, shares of a company with 14 percent earnings growth could be a very attractive value at a P/E of 16 or even 18. But the same stock would be fully priced at a P/E of 25 or more.
Analysts sometimes compare a stock's P/E with its growth rate, calculating a P/E-to-Growth (PEG) ratio. PEGs from 0.9 to 1.4 are relatively cheap. PEGs from 1.7 to 2.0 or more look expensive. The typical blue-chip growth stock has a P/E around 18 and a growth rate of about 12 percent -- for a PEG of 1.5.
When considering growth, it also makes sense to factor in dividends. It's possible to approximate a stock's long-term total return potential, for instance, by adding its earnings growth rate to its dividend yield. Then, you can divide the P/E by that estimated return.
A stock with 12 percent earnings growth and a stock with 9 percent earnings growth and a 3 percent dividend yield will get the same score, if both are trading at the same P/E.
For some stocks -- particularly for companies such as oil drillers and cable TV operators that have large depreciation expenses -- cash flow provides another reliable benchmark for value.
You can find the amount of cash a company generates each year listed in brokerage reports or other standard research sources, such as the Value Line Investment Survey (some firms also report EBITDA, a similar measure). When a stock is selling at less than 10 times cash flow per share, it may well be a compelling value.
Whichever point on the growth spectrum you favor, remember that the key to long-term profits is consistency. Companies with above-average growth that you can buy and hold indefinitely are the most valuable additions to your portfolio. Since commissions and other fees are a significant drag on returns, the less often you buy and sell, the better.