Don't Fall Into the Growth Trap

Over the past year, you've heard plenty of warnings about value traps -- the allure of mature businesses that suddenly look cheap after a big market drop. As unfortunate investors in stocks like General Electric (NYSE:GE) can attest, just because share prices have fallen a bunch doesn't mean they can't keep falling further.

What hasn't gotten as much investor attention thus far, however, is a different trap that primarily affects growth stocks. As the economy slows, many high-growth companies have to face up to falling earnings and revenue growth rates as well. Yet if you put too much faith in analyst estimates of future financial results, you could find yourself making a bad bet on a stock that proves not to be the great growth candidate you thought it was.

Adjusting expectations
With value stocks, the first thing many investors look for is the price-to-earnings ratio. Low P/Es are many value investors' dream, although you have to be careful to avoid the many pitfalls of relying on that measure. Anything from one-time windfall profits that are unlikely ever to be repeated to unusual accounting practices can make reported earnings an unreliable figure on which to base valuation.

For growth stocks, on the other hand, most investors focus on strong future earnings growth. As long as a company can sustain strong growth, it can retain a following of loyal investors and the high valuations that often come with that growth.

But with the economy in recession, growth estimates have started to collapse on many stocks. Below is a sample of how analysts have revised their estimates on next year's earnings for a few growth stocks:

Source: Yahoo! Finance.

As you'd expect, some companies have been particularly hard-hit, while others have only suffered glancing blows thus far. But in the next table, notice how little pessimism analysts have further into the future:

Source: Yahoo! Finance.

Except arguably for Google, each of these companies will face a monumental task in meeting its five-year growth benchmarks after what is projected to be a subpar 2009. For International Paper to reach its 5% five-year projection if it loses more than half its earnings next year, it would have to grow earnings more than 165% from 2010 to 2014. Amazon will have to have 143% earnings growth over the same four years to reach its target. While not inconceivable, those projections rely on an optimistic assessment of the economy's current troubles.

Stay reasonable
The problem with those rosy numbers is that for growth stocks, future estimates form the foundation of a huge part of stock valuation analysis. So if you use numbers that turn out to be highly inaccurate, what seems like a smart investment decision now may prove to be disastrous a year or two down the road.

To stay out of the growth trap, form your own independent assessment of future growth, especially beyond the next two or three years. Analysts are far from perfect at assessing a company's prospects even one year in advance, let alone five -- so don't let an amazing-looking growth rate trick you into buying a dud stock.

For more on investing in growth stocks, read about:

• Growth stocks that turn out to be the best value.
• The secret of millionaire-making stocks.
• A pricey-looking stock you must buy now.