You made it! We are now ready to tackle the final step in our process of analyzing a growth stock. We have done all the exploration we need to determine if the company is a high quality company with realistic and reachable growth targets. Now, we are going to look at valuation metrics to determine if the growth of the stock is a good buy at current market prices. As a reminder, we will be using hypothetical stock “ABC” as our model company.
Part 5 – Valuation Analysis
Valuing a growth company is no easy feat. Traditional metrics often do not apply as investors are purchasing the stock in anticipation of what the company will do and not what is has or is currently doing. Amazon is a classic example of a company whose valuations were out of control. For years the company posted no earnings, yet the company’s share price continued to hit highs year after year. Today, it’s Tesla or any marijuana company currently listed on the TSX. Tomorrow, it will be another. The point is, if you are an investor who relies on fundamentals, then it may be difficult for you to find growth stocks that meet your criteria.
Likewise, to conduct a thorough valuation of a growth company, you’ll probably want to investigate the theory of the discounted future earnings or cash flow methods. These can get quite complex, and can be overwhelming to novice investors. It takes a lot of analysis and you must try and predict the company’s financials over a set period of time in the future and even the best analysts can’t predict with any accuracy expected cash flows for a company.
For our purposes, we will try and use simple and easy to understand methods to value growth stocks.
- Price to Earnings to Growth (PEG) If the company you are looking at is profitable, then the PEG ratio is one of the most reliable metrics to value a stock against future growth. The concept is quite simple. Take the company’s current P/E ratio and divide it by the company’s expected growth rate. The standard approach is that a ratio under 1 indicates that the company’s share price is not keeping up with its expected growth rate and thus is considered undervalued.
Criteria – PEG < 1.0
Revisiting our example of stock ABC, its P/E is 15.72, and its expected growth rate as calculated previously is 28.5%. As a result we can calculate the following: PEG= 15.72/28.5 or PEG = 0.55
Stock ABC’s PEG ratio is below 1 and as a result its current share price can be considered undervalued as compared to its expected growth rate. Along with all the other information we gathered, this may be enough for a buy signal.
- Enterprise value (EV) to earnings before interest, taxes, depreciation & amortization (EBITDA) The EV/EBITDA ratio is a valuation metric that can be used in place of the company’s P/E ratio to determine the fair market value of the company. This ratio is preferred because on its own, the P/E ratio doesn’t mean a whole lot. The general rule of thumb is the lower the ratio the better, and a ratio under 10 is preferred. Likewise, it is best when compared against the industry averages, and a company with an EV/EBITDA below industry averages is typically considered undervalued.
Criteria – EV/EBITDA < EV/EBITDA Industry Average
Stock ABC’s EV/EBITDA ratio is currently 9.66. Unfortunately, the industry average is not available so in this case, we will use a ratio below 10 as our preferred target. Given this, stock ABC looks to be undervalued.
- Price to Sales (P/S) The price to sales (or revenues) ratio is one of the simplest valuation metrics. It takes the current market price of the company’s shares and divides it by the company’s trailing twelve month revenues. Once again, the lower the ratio the better valued the company. It is also best when compared against industry averages. A P/S ratio below the industry average typically signals that the company is undervalued.
Criteria – P/S < Industry Average
Stock ABC’s P/S ratio is currently 1.3, and the industry average is almost double at 2.4. As a result, stock ABC can be considered undervalued as compared to the industry.
Where to access this data?
All these ratios can be found on most financial websites, including Stocktrades.ca! The PEG ratio will most likely need to manually calculated. The industry P/S will be easy to find, but the EV/EBITDA will take a little bit of research.
Recap for Stock ABC
We have now established whether or not your targeted growth stock is a buy at current market prices. Your growth stock analysis guide is now complete and you are ready to make a decision. Are you ready to buy? Add the company to your watchlist? Or move on to another?