Growth stocks are struggling of late and many of them are on sale. In just three months, the ARK Innovation ETF has fallen more than 23% while the S&P 500 has risen by 8%. It can be tempting to buy up many growth stocks right now given their depressed valuations, but knowing which ones are likely to be safe in a year that may be filled with interest rate hikes could be the difference between a good return and a bad one.
Luckily, ratios can help investors put into context a company's valuation and risk. And there's a particularly important one that investors should focus on this year when buying growth stocks.
The interest coverage ratio, also known as times interest earned, divides a company's earnings (before interest and taxes) by its interest expense. Note that although the two ratios are typically used interchangeably, there are some cases in which interest coverage ratio and times interest earned ratio can slightly differ if a company has a significant amount of non-operating income.
As the name implies, the higher the ratio is, the more coverage the company has to pay its interest costs. And that means in the likely event that interest rates rise this year, the business will be in a good position to make its interest payments -- assuming that its profits don't fall. Generally, investors will prefer a company with higher interest coverage as that will mean rate hikes have less of an impact on its bottom line.
The one exception is if the company has no interest expenses at all, which would be rare for a growth company. In that case, the ratio would not be applicable.
Using this ratio on growth stocks is particularly important
For value stocks with solid financials such as bank stocks or ones that pay dividends, the metric isn't going to be terribly useful since those are companies that normally have strong profits to begin with. Growth stocks that are actively expanding their operations, however, will need money to continue growing. And if these companies aren't generating a profit or interest expenses are putting a dent in their bottom lines, that can lead to the businesses issuing more debt or shares -- which will result in dilution for existing shareholders.
Three stocks with vastly different coverage ratios are Regeneron Pharmaceuticals (REGN -1.11%), Tesla (TSLA -3.25%), and fuboTV (FUBO -7.94%):
The healthcare company's operating income over the trailing 12 months has totaled $7.5 billion. And with a modest interest expense of just $58 million during that time, Regeneron investors don't have to worry about the impact interest rate increases will have on the company's financials. It's also no surprise that given the significant coverage, the company has accumulated $5.4 billion in free cash flow during that time. Regeneron is in an excellent position to fund its own growth and its pipeline, which features dozens of ongoing trials.
Automaker Tesla doesn't have nearly as much coverage as Regeneron, but that doesn't mean the company is in dire shape, either. With an operating profit totaling $4.5 billion over its last four quarters, that's still easy enough to cover the $546 million in interest expenses during that time. A company doesn't need 100 times coverage to be a relatively safe stock or even 10 times for that matter, but the ratio does help emphasize the gap between profitability and interest costs, and that can be useful in assessing and comparing stocks.
A stock like fuboTV that's in the highly competitive streaming industry would be much more of a concern. It is not profitable and has burned through $220 million over the past four quarters, just from its day-to-day operating activities. And it may be of little coincidence then that of the three stocks noted here, fuboTV is the only one that has fallen sharply in the past three months, crashing by more than 46% (Regeneron and Tesla are up 15% and 39%, respectively).
Should investors avoid growth stocks with low or negative interest coverage?
Interest coverage is useful for risk-averse investors and those who may be worried about the impact interest rate increase may have on a company's bottom line. If someone's willing to stick with a business that's in its early growth stages like fuboTV, they'll likely have to accept the risk that comes with that -- dilution, limited (if any) profitability for years, and a volatile share price. And in that case, interest coverage may not enter into their analysis.
However, for a growth investor who doesn't want to take on all that risk, then interest coverage is a ratio they should certainly look at utilizing this year.