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Investing for growth
Every portfolio needs a healthy dose of growth. Here's how to avoid overpaying for it.
August 18, 2004: 10:08 AM EDT

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.  Top of page




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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.