Valuations can be misleading
Value investors such as Warren Buffett focus on finding high-quality stocks that are mispriced. However, this style of investing is different from investors focused on hypergrowth.
Companies like Google and Nvidia dominated technological breakthroughs that allowed them to scale up rapidly. In other words, they could grow into their valuations over time as revenue and earnings expanded at an accelerated pace.
For instance, Google shares were trading at 65 times earnings shortly after the IPO. By traditional measures, that would be considered overpriced. However, Google’s earnings per share have expanded at a faster rate than the stock price over the past 20 years, which is why the stock now trades at a relatively modest price-to-earnings ratio of 24.70.
Similarly, Nvidia stock was trading at 247 times earnings per share in mid-2023, a ludicrously inflated valuation. However, the company’s revenue and earnings have skyrocketed since then, which has lowered the stock’s price-to-earnings ratio down to 53.48 this year.
Professional investors understand this and often don’t mind paying the price for relatively expensive stocks that are on the path toward robust growth. Here’s how you can adjust your valuations to account for growth.
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Learn MoreGrowth-adjusted valuation
Professional investors who are focused on hypergrowth companies use a price/earnings-to-growth (PEG) ratio. This is a modified version of the price-to-earnings ratio that accounts for how fast a company’s earnings are expected to grow.
To calculate the PEG ratio, simply divide the stock’s current P/E ratio by the company’s earnings growth rate for a set timeframe. If the ratio is below one, the stock is considered undervalued. Whereas, a PEG ratio greater than one is overvalued.
For example, if a stock is trading at a price-to-earnings ratio of 100 but you expect its earnings to grow by 100% in the upcoming year, the PEG ratio is 1 and the stock can still be considered fairly valued.
Similarly, Google’s current P/E ratio (as of Dec. 23) is 26.01 and if you believe the company can expand earnings by roughly 25% next year, you could consider it a fairly valued investment.
The value of these ratios hinge on the quality of your assumptions. So if your forecast of earnings growth is incorrect, the ratio could be misleading. However, when this valuation tool is used correctly and based on thorough due diligence, it can help you spot companies that are on the path to robust growth over the long-term.
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