A Beginner's Guide to Growth Stocks

Come on, admit it: Like most of us, you gravitate toward the market's highfliers, stocks with sex appeal -- and price multiples that make those of the broader market look like the proverbial chicken feed. Google, (Nasdaq: GOOG  ) and Genentech (NYSE: DNA  ) , for example, sport price-to-earnings (P/E) ratios that sprint past that of the broader market. (Nasdaq: AMZN  ) and eBay (Nasdaq: EBAY  ) , meanwhile, more than double up on it.  

Why are investors willing to pay such premiums? Well, earnings-growth estimates are typically a major factor, but don't discount the aforementioned sex appeal: Not for nothing do these stocks garner miles of financial-press column inches. They also make the P/Es of stalwarts like Chevron (NYSE: CVX  ) , Wyeth (NYSE: WYE  ) and Goldman Sachs (NYSE: GS  ) -- all of which are lower than the S&P's -- look positively paltry by comparison.

How to proceed
If you find yourself besotted with racy growth stocks, your smartest move is to take a cold shower. Remember that the higher they fly, the farther they have to fall when Mr. Market takes a tumble. Just ask folks who were invested in the growth-heavy Nasdaq 100 Trust (QQQQ) exchange-traded fund back in early 2000 -- right before the bottom fell out of the market. More than seven years later, those investors are still waiting to see a positive return on their investment.

The good news is that it doesn't have to be that way -- especially not these days. Large-cap stocks of the growth persuasion have been out of favor on a relative basis ever since the market experienced its pre-millennium meltdown. The upshot? Now appears to be an excellent time for investors to go growth shopping. After years of market-lagging performance, that seems to be where the market's bargains lie -- provided you know how to find them.

Three rules of thumb on that front are:

  1. Follow the cash flow. Among the big boys, favor growth-oriented companies with a proven ability to generate cash and plow sufficient sums back into expanding their businesses. That's a winning combination -- particularly if they hope to meet those outsized earnings estimates.
  2. Compare like with like. Seemingly above-average multiples can be misleading. A P/E of 25 looks high relative to the broader market's P/E (roughly 18) but not so much relative to, say, that of the average biotech company (roughly 26).
  3. Don't go whole hog. Be sure to own growth stocks in the context of a well-diversified portfolio that includes more mild-mannered fare. That's a smart way to work toward financial freedom -- and to get your beauty rest at night.

The Foolish bottom line
With that as a backdrop, Ready-Made Millionaire -- the Fool service that aims to provide a set-and-forget investment solution -- features a compact, real-money lineup that tilts toward large-cap growth but also provides choice exposure to small- and mid-cap stocks and value-priced foreign fare, too. Our mission: to sail past the market's average of the next three to five years via intelligent asset allocation and ace investment selections.

RMM will reopen to new members later this month. Between now and then, we invite you to learn more about the service by clicking right here. You'll be able to snag -- for free -- our 11-Minute Millionaire special report, which is designed to help you navigate up markets and down, and we'll make sure you're among the first to know when RMM's doors swing open again.

This article was originally published on April 5, 2007. It has been updated.

Shannon Zimmermanruns point on the Fool's Ready-Made Millionaire service and doesn't own any of the securities mentioned above. and eBay are Motley Fool Stock Advisor recommendations. Google is a Rule Breakers choice. The Fool has a strict disclosure policy.

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