Welcome to Ameritrade Plus University
investing 101Investing for growth
Aiming for a realistic return
Identifying your real risks
Putting together the right portfolio
The psychology of investing
Investing for growth
Seven questions to ask before buying a growth stock
How to spot value
Selecting stocks for income
How to buy bonds
Preferred shares: uncommon values
Convertibles: the best of both worlds
Closed-end funds: their time will come again
The right way to use stock options
Mergers and acquisitions
Frequently asked questions I
Frequently asked questions II
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Every portfolio needs a healthy dose of growth. Finding it is easy -- here's how to avoid overpaying for it.

Stock prices follow earnings. In fact, over a long stretch of time, rising corporate profits are the only force that can keep share prices moving higher. Investors may decide to pay more than average prices for the earnings of a popular company, and that boosts the price/earnings ratio. But while rising P/Es can lift share prices for a few years, there's a limit to how high they can go.

As a result, growth investing, or seeking out companies with above-average earnings growth, should be a key part of your strategy. It's also the simplest approach to the stock market.

Historically, the S&P 500 has returned around 12 percent per year. So if you can find a company with earnings growing faster than that, the stock will eventually outpace the market -- provided its earnings come through as expected and that the stock was fairly priced to begin with.

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 company's P/E to its projected earnings growth. Ideally, you don't want to buy at a P/E that's much more than the growth rate, and in a normal stock market, there are plenty of such bargains. But over the past five years, they have become harder and harder to find.

Today most high-quality companies with double-digit earnings growth have P/Es that are at least 1.5 times their growth rate. For example, shares of a company with 14 percent earnings growth would trade at a P/E of 21 or higher. If you're interested in the most popular growth stocks, you may have to grit your teeth and pay even more -- P/Es that are double the growth rates, for instance. But you have to draw the line somewhere. Hold off on buying stocks that are trading at P/Es more than twice their growth rates, no matter how good the companies are. When a stock company with a P/E that high stumbles, its shares can fall hard.

Some of your best bargains will be found at the opposite end of the spectrum, with companies that have earnings growth around 12 percent. With those stocks you may want to add in the dividend yield to get a total return estimate. For instance, a stock with 11 percent growth and a 3 percent yield might really be able to return a total of 14 percent. Getting a stock like that for a P/E below 20 could be a great deal.

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 spot 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 for individual investors, the less often you buy and sell, the less you have to think about expenses. In addition, if you don't trade much, you won't have to worry about mistakes in your timing.

Seven questions to ask before buying a growth stock >>


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