Growth stock

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Growth Stocks in finance, are stocks that appreciate in value and yield a high return on equity (ROE). Analysts compute ROE by taking the company's net income and dividing it by the company's equity. To be classified as a growth stock, analysts expect to see at least 15 percent ROE.

An investor's return typically comes from three places:

Return from appreciation of the original investment
Return from dividend payouts
Return from the retained earnings reinvested by the firm

With growth stocks, the companies seldom issue dividends, so the investors return comes from the other two sources.

The market sometimes values a stock at an amount much more than the book value contained in the companies' accounting records. In such a case, the PE ratio will likely be relatively high. Can investors pay a high PE for growth stock and still achieve a substantial investment return?

Also known as a "glamor stock".

Example to show why investors pay a high PE for growth stocks

This important principle creates the opposite of a modified internal rate of return. Thus, it creates an accelerated two-part rate of return for the investor. An example follows:

Equity $100,000

ROE 30%

Investor pays $1,000,000 or a P/E of 33 and thus first year earnings return equals 3%.

However, the investors ROE does not remain at 3% even as we assume that the companies ROE remains at the above stated rate.

Why? The new reinvested earnings earn the companies ROE rate. Demonstrated as:

First year -- $39,000/$1,030,000 equals 3.8%
Second year -- $50,700/$1,069,000 equals 4.5%
Third year -- $65,910/$1,119,700 equals 5.9%
Fourth year $85,683/$1,185,610 equals 7.2%
Fifth year $111,387/$1,271,293 equals 8.7%
Sixth year $144,803/$1,382,680 equals 10.5%
Seventh year$188,244/$1,527,483 equals 12.3%
Eighth year $244,717/$1,715,727 equals 14.3%
Ninth year $318,132/$1,960,444 equals 16.2%
Tenth year $413,575/$2,278,576 equals 18.1%

Assuming the 30% ROE continues for ten years, the company's earnings will be $413,575.

Assuming the ROE now drops to 10% and the company’s earnings are paid out to the investor as a dividend, the investment would be worth $413,575 / .10 or ~ $4,100,000. The investor’s IRR would equal ~15%.

If the residual earnings are capitalized at a 15 P/E the investors return equals ~18%. Using either scenario for the residual sale, the investor earned an above market rate of return.

In conclusion, the investor’s success depends on the ROE of reinvested earnings. Of course, the company’s ROE depends on the their ability to create products, market those products, control costs, hire and keep competent management and employees and continue to successfully employ capital over the long term – no small feat. In the end, an investor can pay a high P/E and still come out with an excess market rate of return if they pick a well managed firm with a high growth rate.

Growth stock

Example to show why investors pay a high PE for growth stocks

See also