This article is from the How to Start an Investment Program tutorial, author unknown.
In tandem with the P/E ratio, the growth rate of a company provides a very useful measure to determine the value of a company's stock. There is a simple rule of thumb to follow: the P/E ratio of a growth stock should, in a fairly valued situation, equal the growth rate of the company's earnings. Plain and simple.
Using Dentsply again as an example, if the P/E of the company is determined to be 20, you would like the rate of earnings growth for the company to be 20 or more. If the growth rate is found to be significantly higher, you may have a bargain on your hands. If, on the other hand, the growth rate of Dentsply is found to be 10, the stock may be due for a significant correction.
You know how to determine the P/E, so now let's go over how to come up with the growth rate. There are several ways to do this so I'll start with the one that is easiest. For those of you utilizing a full service broker to handle your trades, just call them up and ask them to give you the stock's growth rate. They should have no trouble coming up with this figure. For the rest of you, here's are the steps to follow.
First, you need to find the annual earnings of the company. Then, calculate the percentage increase in earnings from one year to the next. For example, if Acme Dental Supply saw earning rise from $1.50 per share to $1.75 per share, you would take the $0.25 increase and divide it by the original value of $1.50 to obtain the rate of growth of 16.%. ($1.75 - $1.50 = $0.25; $0.25 / $1.50 = .16 or 16%). In a fairly valued situation, the P/E of Acme should be in the neighborhood of 16. If the P/E is lower than 16, it is probably a good buy.
If the company you are examining pays a dividend, you may want to use this slightly more complicated formula. First, find the long-term growth rate (we'll use 16 from above), add the dividend yield (Acme pays 2 percent), and divide by the P/E ratio (Acme's is 10). The math works out this way: 16 + 2 = 18 / 10 =1.8. In using this method, the threshold number you are looking for is 2. If your growth rate calculation comes out 2 or better, this is a very good sign. If the number is closer to a 1, you probably want to look for a different stock.
There are other, more complicated formulas for determining the growth rate. Some take into account a constant growth, while others assume a nonconstant growth forecast. What is most crucial for the investor is the estimation of the FUTURE growth rate. This bit of crystal ball gazing for small growth stocks is, for the most part, an educated guess and is best left up to the pro's with their sophisticated computer models. Fortunately, most small stocks are covered by at least a few of analysts, allowing you to sift through their numbers and decipher their opinions before you commit yourself.
This concludes the section on how to find value in growth stocks. If you find this introductory material has piqued your interest, I would encourage you to read more on the subject and/or discuss the various valuation techniques with your broker or financial advisor.