Dangerous Growth

Bigger is better. Growth is good.

Really? Sure, a company with more book value, more (profitable) sales, and more earnings that can be distributed to its shareholders is more valuable than a company without such attributes. And a fast-growing company is more valuable than a slow-grower, if it means the former will get "big" a bit sooner. I disagree with the established wisdom, though, when it takes the above truisms and tries to force the facts to fit.

For example, consider the humble PEG ratio. It's one of the simplest methods available for gauging the valuation of a company's stock, and it consists of three elements:

  • Price
  • Earnings
  • Growth rate

Calculating a PEG takes just two easy steps:

  • Divide the price by the earnings to get the P/E, then
  • Divide the P/E by the growth rate

That's where the trouble begins.

Square holes and round PEGs
According to the prevailing wisdom, if you can find a stock whose PEG is less than 1.0, you've got yourself an undervalued company. The problem? People really want to find undervalued companies, and they're liable to stretch the definition to fit the facts.

One way to stretch the PEG ratio is to be too optimistic about growth rates. It doesn't matter how big a P/E a company has. Divide it by a sufficiently high growth rate and you can find yourself a less-than-1.0 PEG any day of the week.

Let's take a look at some examples. There's Google (Nasdaq: GOOG  ) at $380 and a 67 P/E. That's not a problem if you assume earnings grow at 75% a year. Then there's Salesforce.com (NYSE: CRM  ) at $32 and a 128 P/E. Strap on a 150% growth rate and you're good to go. What about TaserInternational (Nasdaq: TASR  ) and its 335 P/E? Hmm, this is getting difficult ...

When dealing with bat-crazy scenarios like these, individual investors often need a crutch to help reassure them that the wildly improbable isn't actually impossible. Enter Wall Street's analysts and their "consensus earnings estimates." Peering into globes of Kristall, reading scattered entrails-of-goat, and burning the incense (not the midnight oil), they call out their oracles of future earnings.

Investors, hanging on every word, dutifully plug the numbers into their PEGs and sigh in relief: "Thank goodness Sirius Satellite Radio (Nasdaq: SIRI  ) and XM Satellite Radio (Nasdaq: XMSR  ) are going to grow 20% or more. I was worried there for a minute, when I saw they didn't have any profits yet."

Price check, please
Unfortunately, analysts are far from infallible. And what's more unfortunate is that when analysts make mistakes, it's the investors -- who have trusted those analysts with mind, body, and checkbook -- that suffer. According to Professor Aswath Damodaran of the Stern School of Business at New York University, "When it comes to forecasting growth, analysts have a tendency to overestimate growth, and the mistakes they make are highest for long-term forecasts."

Wait, it gets worse. Professor Damodaran continues, "As for pricing growth, markets historically have been more likely to overprice growth than underprice it."

Congratulations, investor: You've just been handed a double whammy. Trust Wall Street's growth estimates, and you'll generally find they're overoptimistic -- the growth simply won't materialize. To add injury to insult, because you overpaid for that fast-grower-that-wasn't, when the growth fails to materialize, your stock price has even farther to fall.

The world according to GARP
What exactly is the solution, then? Elementary, my dear Robin Williams fans. Buy stocks that promise realistic "Growth At a Reasonable Price" (GARP). That's the philosophy we espouse at Motley Fool Stock Advisor, the Fool's flagship newsletter for investors who want to maximize profits and minimize risk.

At Stock Advisor, we've beaten the market by an average of 42% during the past four years. And we've done it by sticking to three principles:

  • Don't overpay.
  • Don't make crazy assumptions about future growth.
  • Do invest in proven growers -- companies that don't just have bright futures, but also have established track records of market-beating growth under their belts.

Investing in companies like BorgWarner (NYSE: BWA  ) , an auto parts manufacturer that's expected to grow at 12% per year in the next five years -- and has racked up 19% annual growth during the past five years -- has treated Stock Advisor members to 135% gains in the past three years. And our recent pick of GameStop (NYSE: GME  ) wasn't based solely on its projected 17% future growth -- but also on its proven ability to grow at 31% in the past. After just four months in our portfolio, GameStop is up 42%, which is 40 points better than the S&P 500.

Want to learn more about these two recommendations? You can read our full write-ups on each, and on the 98 other recommendations we've made over the past four years, free of charge. All you have to do is take a free 30-day trial of Stock Advisor. Click here to get started.

Fool contributor Rich Smith does not own shares of any companies mentioned above. If he did, he'd have to tell you so. Fool's honor. Taser and XM are Rule Breakers recommendations.


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