How to analyze growth stocks
A tool that is extremely important when it comes to growth stocks analysis is the delta of the delta. We will use Visa as a growth stock example and by the end of the article you will have another valuable tool when it comes to assessing the risk and reward of an investment, in this case a growth stock. The following chart explains the growth stock analysis we will discuss and what you’ll fully master by the end of the article.
Growth stocks – The decade ofgrowing valuations
The last decade has been the decade of growth stocks. The Nasdaq index is up almost 6 times over the last decade.
That is an amazing performance and tech businenesses,growth stocks, did perform really well over the past decade. However, did thosebusinesses perform as well as their respective stock prices?
Microsoft’s (MSFT) price to earnings ratio increasedfrom 7.5 in 2011 to the current 30.
Source: MSFT growthstock – Macrotrends
Such an expansion in valuation means that investors’ expectations considering growth have also been constantly growing in comparison to what they expected at the beginning of the decade.
Similarly, Visa’s PE ratio expanded from 15.5 in 2010 to the current 33.5.
Source: Visa growth stock – Macrotrends
Such valuationexpansions tell us that investors expect strong growth rates going forward thatjustify paying a relatively high price for a growth stock. The expectation offuture growth, in combination with current growth, is what keeps the stockprice going higher and higher as investors combine current strong businessgrowth with even higher expectations of growth in the future. This leads togrowing PE ratios and consequently constantly higher stock prices.
As investors, wehave to look at the key factor that will influence future investment returns:the delta of the delta – the change in the growth. I have recently analysed Visa stockand it will serve as a great example for the application of this tool. Let megive you first a quick introduction to Visa’s stock and then we’ll apply thetechnique to make a Visa growth stock analysis.
VisaGrowth Stock Analysis
Visa Stock (NYSE:V) is the ultimate compounder. Revenuekeeps growing, earnings and cash flows too, that leads to constantly higherdividends while the market for Visa simply keeps increasing thanks to globaleconomic growth.
Visa growth stock – revenue growth
I have two bank accounts; one is Visa the other isMasterCard. I think if you open your wallet, you’ll probably find a Visa card.
Visa Stock Growth Performance
When you look at what Visa did in the past, it is simplyamazing. Over the last decade, revenues more than tripled, net incomequadrupled and the dividend was increased by a factor of 10.
Visa growth stock – dividend growth
With such financial metrics, the only outcome for a stock isto skyrocket.
Visa stock growth – stock price performance
Visa stock analysisand valuation
On the other hand, Visa’sstock also comes with a high valuation and low dividend. The whole game withVisa stock is that it has to continue to grow and compound for the stock priceto keep growing. As soon as the growth slows down, there will be a big hit forthe stock too.
Fortunately for Visa stock holders, the company just keeps on giving and giving. They have a low dividend payout ratio of around 20% because they can reinvest capital at rates above 20%.
Visa stock profitability
Source: Visa Stock Morningstar
The company has all what you can dream about when it comes to investing; growing revenues, a high margin, high return on invested capital alongside constantly growing distributions to shareholders. Apart from the dividend, the number of Visa stock outstanding fell from 3 billion to 2.2 billion over the last 10 years. That is almost 30% less than the number of Visa stocks outstanding in 2009!
Visa’s growth comes from their strong moat that is also reflected within their extremely high net profit margin of 50%.
Visa stock business performance
Source: Visa Stock Investor relations
Visa stock growth outlook
The outlook is simple when it comes to Visa stock. For as long as the company can keep growing earnigns at 15% per year, the stock will follow. The menagement expects the company to continue to grow earnings in the mid-teens range.
Visa stock earnings outlook
Source: Visa Stock Investor relations
Visa growth stockinvestment analysis
When it comes to investing, it all depends on growth. If there is an economic halt, Visa’s traffic and profitability could stagnate for a while and consequently the stock would stagnate too. Visa is definitely a business that compounds, but I would say fairly priced given the PE ratio of around 30. If earnings continue to compound at 15% per year, the PE ratio on the current price will be just 15 in 5 years and just 7.5 in 10 years. The stock price will consequently grow alonside earnings growth at a constant valuation.
Visa earnings analysis
So, the questions are:
- Will Visacontinue to grow as fast for a long time?
- What happens ifVisa’s growth is in the low teens or in the high teens?
The answers to the questionswill be given by the delta of the delta tool that looks at the change in thegrowth rate.
The change in the growth rate – the delta ofthe delta growth stock analysis tool
For example, if Visa’sgrowth, that is expected to be at 15% going forward, falls down to 10% peryear, everything would change from an investing perspective. This is counterintuitivebecause 10% yearly growth is still amazing, but it might not be what is bakedinto the stock price.
If Visa’s earnings grow 10% over the next 5years, earnings per share would grow from the current $5.32 to $8.71 and not to$10.70 as it would be the case with 15% growth.
You might think how thisdoesn’t really make a great difference. Well, the change in growth makes allthe difference. The market is willing to pay a price earnings ratio of 33 for15% yearly growth. If the growth falls to 10% and the growth trend is slowingdown, the market might want to pay a price to earnings ratio of just 20 forthat. Thus, in five years, earnings per share of $8.71 with a PE ratio of 20would lead to a stock price of $174, a stock price close to current levels.This would meand investors would look towards zero returns in the coming 5years, despite the fact that the company is still growing at 10% per year.
The same works on the upsidetoo. If Visa manages to grow at 20% per year, earnings per share would go from$5.71 to $14.2 over the next 5 years and the market would probably value thestock with a PE ratio of 40 and the stock price would reach at an incredible$568.
But this is the magic ofgrowth stocks and when you analyze growth stocks, the key to watch is thechange in the growth rate, i.e. the delta of the delta.
Growth stock analysis conclusion
The best way to apply thedelta of the delta growth stock analysis tool is to use it for investment risk andreward analysis:
- What is theprobability that Visa growts at 20%?
- What is theprobability that we have a global slowdown over the coming 5 years and thatVisa’s growth falls to single digits?
The delta of the delta growthstock analysis tool gives you a range of what you can expect qua valuations,stock price targets and investment returns in relation to the growth rate.
Growth impact on stock price:
- Growth matchesexpectations
If the growth matches thegrowth expectations, the stock price will likely grow at the same rate of thegrowth.
- Growth rate beatsexpectations
If the growth rate beatsexpectations, the stock price will likely growth even faster as investors willgive it an even higher price to earnings ratio in expectations of even higherearnings in the future due to faster growth. This is the case where Visa stockcan easily grow form $178 to $568 over the next 5 years.
- Growth rate belowexpectations
If the growth rate fallsbelow expectations, all the exuberant fellings quickly turn cold, the marketgives a much lower valuation to the stock and consequently the stock price canfall a lot. This is why investing in growth stocks is considered risky and whyinvestors expect a high return when doing so.
I hope this helped toincrease your tool box when it comes to investing. It is a simple technique butso important when it comes to assessing investement risks and rewards of agrowth stock. If you with to learn more, please check my FREE Comprehensive Stock Market Investing Course – did I mention it is FREE? It has many similarlectures, both in video and written form.
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