How to Tell if a Growth Stock Can Keep on Growing

Jack Hough of the WSJ & Smart Money put together a good article that lays out several metrics to arrive at an intrinsic value for a company.  The real key to the article in my mind is that there is no one way or right way to arrive at a company valuation.


At DWCM we use several fundamental metrics to arrive at a relative score.  Based upon the score (the higher the better) determines weather we move forward which warrants additional fundamental analysis based upon the company in addition to a few technical analysis indicators.


Highlights via the WSJ article here that offer sound investment advice

• To tell whether earnings growth is sustainable, use a mix of qualitative judgments and metrics, says Tim Koller, a partner at McKinsey who advises companies on valuation. He favors companies with strong brands to those with merely hot products, such as the latest well-received iPhone competitor. 
• He also urges caution on businesses that continuously run up against large, new expenses as they expand, like many retail chains. And he looks for businesses whose customers would find it costly or inconvenient to switch to competitors—think Facebook users deciding whether to tote their digital lives to Google Plus.
• Another place to spot sustainable growth is a measure called "return on invested capital," which is listed on some stock-quote websites. The measure shows whether companies are finding lucrative projects that can power future growth. Today, numbers in the 13% to 16% range are ordinary, while those above 30% are excellent, Mr. Koller says.

• Mr. Koller favors another method for telling which growth stocks are worth their prices: working backward on the math. Use an online calculator to figure out what the share price would be after a decade of 10% yearly growth—the market's historic average, not subtracting for inflation. For Chipotle, that would increase its share price from $398 to $1,032.
• Next, assume today's high P/E ratio (about 46 for Chipotle) will have fallen to 15 a decade from now, roughly the historical average for stocks, because companies don't grow quickly forever. (Use a lower or higher number to make projections more conservative or aggressive.)
• Then figure out how much earnings are needed to support the future stock price: about $69 a share for Chipotle. That would require it to meet Wall Street's $8.70 a share forecast for this year and boost earnings at a compounded rate of about 26% a year for the next nine—no easy feat.