Valuing Growth Stocks

Growth stocks tend to have distinct features that separate them from other stocks and make them more challenging to value. They usually don't pay dividends, hence dividend valuation models can't be applied. Their future earnings are likely to grow, and thus one cannot simply use financial metrics that assume a stable earning income. Even popular DCF (Discounted Cash Flow) models can prove to be very difficult to use, since the uncertainty about the future raises doubts about the validity of the parameters used.

This guide explains one of key metrics we use to value growth stocks relative to their peers. Rather than calculate an explicit intrinsic value of a stock, this method helps an investor decide which stock to pick among comparable alternatives.

The Price/Earnings Ratio & its Interpretations

One of the most widely used measures of relative value is the P/E ratio. You're probably familiar with it but we need to discuss it briefly before talking about the implied P/E. Since the P/E ratio is just the price over earnings, there are two main interpretations for it:
  1. 1- It is the dollar amount investors are willing to pay for $1 of earnings. Hence a P/E ratio of 20 means investors are willing to pay $20 for each dollar of earnings the company generates. This interpretation is the more widely popular one.

  2. 2- It is the number of years the company will need to earn back its share price if earnings remain at the current level. Thus if a company is trading at $20 and has a P/E ratio of 30, this simply tells us that it will take this company 30 years to earn the $20 that we paid for its share (again, assuming earnings remain constant).

Weakness of the Price/Earnings Ratio

There are several weaknesses to this popular ratio that should make us very wary of using it.

First, only the trailing years earnings are used in calculating it. Thus it does not factor in any future prospects of the company. In practice, the stock can take a dive if the market expects a negative event to take place soon. This can send the P/E ratio down, giving some investors the impression that the stock is undervalued. An expected positive event can have the opposite effect.

Second, one good quarter can send the ratio way down, giving the impression that the stock is undervalued when it could be a temporary earning bump. One bad quarter can also have the opposite effect. Overall, it is too simplistic to place too much weight on just the trailing four quarters.

The Forward Price/Earnings Ratio

An alternative that investors came up with was the Forward P/E ratio. Rather than using the earnings of the trailing four quarters, the Forward P/E typically uses the expected earnings of the next year. Unfortunately, although this ratio slightly mitigates the problem of using only past data, it still suffers from the other issues of the P/E. Namely, a good/bad quarter can greatly skew the ratio. Furthermore, no information beyond the next year is utilized. A stock can be expected to have a great year but a tough future beyond that point.

The Implied Price/Earnings Ratio

The Implied P/E ratio was meant to be a more informative measure of a metric that people are already familiar with and like. Everyone knows the P/E ratio, and so the Implied P/E simply aims to be an improved (or alternative) version. The idea stems from the second interpretation of the P/E ratio (shown above). Rather than assume that earnings are constant, the Implied P/E assumes earnings shall grow/decrease during certain time periods in the future.

A Simple Example: BABA

Note that the numbers in this example have changed since writing this article, but the example has been left here for illustration.

Let's consider Alibaba stock as an example. BABA is currently trading at a P/E ratio of about 50. This is considered quite high (though nowhere near as high as AMZN). Let's use the Implied P/E calculator to find a reasonable Implied P/E.

Analysts currently expect BABA earnings to grow at an average annual rate of about 30.50% over the next five years. Suppose we believe this to be reasonable, and suppose we believe after those 5 years BABA will grow at a modest 7.5% for 5 years and then stabilize with 0% growth. Then we can adjust the sliders to reflect our beliefs and get a reasonable Implied P/E of 12.66.

Interpretations of the Implied P/E

The Implied P/E can be simply interpreted as the number of years it would take the company to earn its share price assuming the growth estimates used are true. Hence the Implied P/E is a personal metric: Every person has their own Implied P/E for a stock. It depends on a persons expectations, optimism, and personal analysis of a stock.

Nonetheless, in many cases it does make more sense than the P/E. In the example above, it is clear that BABA is not going to take 50 years to earn its share price. BABA is growing. The question is, how much will it grow?

Reasonable assumptions are important here, and this ratio does suffer from the garbage in garbage out problem. If the assumptions used in the BABA example aren't too far off, then the Implied P/E ratio of 12.66 tells us that the BABA stock price is not unreasonable. After all, its market share and very large market cap do command a premium; many large cap companies trade at P/E ratios above 20 despite having little or no growth. The reason being that large companies are believed to be more capable of protecting their earnings and market share. Investors are willing to pay a premium for this.

The PEG Ratio and its Problems

Another alternative that many people choose to use is the PEG ratio. The idea is simple, take the P/E ratio and divide it by the expected growth rate (typically the 5 year annualized growth rate). A PEG ratio below one can be interpreted as undervalued. Some people believe this ratio is better as it incorporates the growth rate into the P/E.

Unfortunately this ratio also suffers from issues. Suppose stock A has a P/E ratio of 10 and growth rate of 5%. Stock B has a P/E ratio of 30 and growth rate of 15%. Then both stocks will have a PEG ratio of 2. However, using the Implied P/E calculator, and assuming both stocks don't grow beyond the 5 years, Stock A will earn back its share price in about 8 years while Stock B will take about double that time. Thus the PEG ratio attempts to be a simple measure incorporating future growth but can be deceiving in many cases.