Growth investing

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7. Earnings growth

Growth investing is all about growth in earnings, because over time earnings and share price are closely linked.

To understand why this should be so, go back to the basic principles of compounding:

Example

Example

Hanson share price and EPS 1977-1992

But the link between earnings and share price is not the same for all companies. Some earnings are valued higher by the market than others, and this is reflected in each company's Price Earnings (P/E) ratio:

Example

The two companies have identical earnings, but one is valued twice as highly as the other. Why?

The reason is that the share prices of companies reflect not so much reported earnings but projected earnings - in other words, what the market thinks a company is going to achieve in the coming one, two and three years. In the above example, the market clearly thinks that Company Y's earnings are going to grow much more quickly than Company X's.

That's fine but how does an investor inject some methodology into the valuation of earnings? The significance of the PEG ratio, popularised by Jim Slater, is that it relates the projected earnings of a company to its estimated growth rate, and comes up with a 'code' for deciding whether it is a good investment or a bad one.

1. What is a growth stock? 2. Comparison with value investing 3. Traditional characteristics of a growth stock 4. Anatomy of a growth stock - Peter Lynch 5. Ten dos and don'ts from Peter Lynch 6. Jim Slater - The Zulu Principle 7. Earnings growth 8. The PEG factor 9. Competitive advantage 10. Do growth stocks have to be small? 11. A short diversion into internet stocks 12. When to sell a growth stock 13. Other factors 14. Case study of a growth stock - Sage 15. Conclusion

• Valuegrowth Investing - an Investor's Guide
• One Up On Wall Street