valuation

Introduction

In part one of this series we introduced the notion that in all markets whether bear or bull, there will always exist individual stocks that are fairly valued, overvalued or undervalued. In this same vein we argued that it’s a market of stocks, not a stock market. For those who missed it, here’s a link to part one. To put this into context, we are simply suggesting that the discerning investor can always find bargains if they are willing to look and do their homework.  However, we should also add that bargains can come from many different types of equities.

Therefore, this and the following articles in this series will look at bargains that can be found within various equity classes.  In this part two, we will look for bargains in high-growth stocks. Although this may be the riskiest equity asset class of all, it is also the most profitable, as long as sound and prudent investing principles are adhered to.

High Growth Stocks Defined

One of my favorite quips is about Tennessee Ernie Ford leading his church’s choir when he allegedly said: “everyone turn to page 26 and sing along with me, but if you don’t have page 26 then sing page 13 twice, because we all need to be on the same page.” Therefore, as it relates to this article, in order for us all to be on the same page, we need to share a common definition of growth stocks, before a fair and impartial analysis can be conducted.

Consequently, for purposes of this article, we define growth stocks as follows: In order to be considered a growth stock, the company must have a history of growing their earnings in excess of 15% per annum, while simultaneously possessing a forecast expected future growth rate of at least 15% or better. For companies that possess these levels of past and future growth, we will utilize a PEG (PE equals growth rate) formula to calculate fair value. The valuation theory being applied states that companies possessing these significantly above-average growth rates deserve a premium valuation over slower growing peers.

The premium valuation concept presented above represents one aspect of why growth stocks, under our definition, possess higher risk than blue chips. First of all, achieving these high levels of growth are not only rare, but also extremely difficult to accomplish.  Consequently, it is a challenge for companies to maintain high rates of growth, and this challenge is amplified the bigger the company gets.  Therefore, we offer this very important caveat.  Regarding growth stocks, it is even more imperative to focus on future growth over historical growth, than it is for any other equity class.

There is a second factor related to the above caution and that is the importance of valuation.  Typically, Mr. Market will ask the prospective investor to pay a higher valuation (PE ratio) to buy a growth stock than most other equity categories. Having to pay a higher valuation for above-average growth is usually not only necessary, but also rational to a point.  In fact, due to the high rates of potential growth, coupled with the power of compounding, means that above-average rates of return can be achieved with growth stocks, even if you pay a little more to buy one than you should. In other words, the compounding power of rapid earnings growth can bail you out from an aggressive purchase over time.

On the other hand, one of the most common mistakes investors make with high-growth stocks is overpaying for them.  This usually occurs because of the hype that often leads to hysteria which tweaks the greed response.  Companies with extremely high rates of growth can for a time attract significant investor interest leading to incredible short-term momentum.  Consequently, a rapidly rising stock price can excite investor greed to the point of irrational behavior. One place where this psychological response is often seen is with hot IPOs.  Later in this article we will present a vivid example of how dangerous this can be.

High Growth Stocks in the S&P 500

This series of articles is oriented to dealing with the wide diversity of equity classes that make up the S&P 500.  Therefore, we are only going to concern ourselves with high-growth stocks that are constituents of the S&P 500.  Of course, this also means that there are many very high-growth stocks that will be excluded from this discussion.  Consequently, what follows is by no means presented as a comprehensive list of high-growth stocks.

Moreover, and most importantly, the following tables comprised of high-growth stocks in the S&P 500 also had to meet the hurdle of reasonable valuation. As a result, there were several S&P 500 growth stocks that did not make the cut.  In other words, the following tables look at S&P 500 high-growth stocks that appear to be at or near fair value based on expected future rates of growth.  S&P 500 growth stocks that we believe are overvalued were not included.

We have listed 17 S&P 500 high-growth stocks that met our criteria and we have organized them based on capitalization and earnings growth rate.  Interestingly, all of the S&P 500 high-growth stocks that made our list are large-cap companies.  Our first table reports on seven companies with earnings growth rates exceeding 20% per annum (The reader should note that both the 15-year historical EPS growth rate and the estimated 5-year EPS growth rate are both in excess of 20% in table 1).  Our second table covers 10 additional S&P 500 growth stocks with historical and estimated growth rates in excess of 15% per annum.

Both of the following tables provide a summary of important fundamental measurements.  The first two columns list historical earnings growth, followed by forecast EPS growth rates.  The next two columns are focused on valuation by showing the historical normal PE followed by the current market PE.  Then we provide debt levels and sector, followed by annualized historical performance, and finally, an estimate of future potential compounded annual rates of return.  (It is important to note that the reader should understand that any companies on the list with poor historical returns (highlighted in red) can be assumed attributed to beginning overvaluation).

Analyzing S&P 500 High-growth Stocks Through the Lens of F.A.S.T. Graphs

Next we’re going to evaluate several examples from our list of S&P 500 high-growth stocks in value, utilizing the F.A.S.T. Graphs™ fundamentals analyzer software tool.  This exercise will serve the dual purpose of allowing us to analyze the fundamental value of each company and to illustrate and elaborate on several of the points previously presented in this article.  Furthermore, although we believe that the following analysis provides a comprehensive evaluation of the fundamentals underpinning each of these examples, additional due diligence is recommended.

Cognizant Technology Solutions (CTSH)

Cognizant Technology Solutions Corp (NASDAQ:CTSH) is a leading provider of custom information technology, consulting and business process outsourcing services. The following earnings and price correlated graph on this quality company depicts a

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