Valuing Stocks – What Are Growth Companies?

While there’s no formal definition of the terms, a ‘growth company’ or ‘growth stock’ generally refers to a company that is still in the building phase of its business. Companies that aren’t in growth mode are usually classified as mature and their stocks are deemed value stocks or cyclical stocks.

Let me give you a quick historical recap. Value investing has been a popular strategy for most of this century. The strategy involves finding companies that hold substantially undervalued assets. Specifically, investors want to buy stocks trading below a company’s tangible book value. Value investors figure that these companies will be worth more even if they are liquidated (the worst-case scenario). Thus, they attempt to limit their downside.

It’s not easy to find high-quality companies trading at or below their book value. Yesterday’s value investors also shunned the practice of predicting future cash flow streams because they averred that you can’t possibly know how much cash a company will generate in the future. But today’s value investors do care about future profits and use price-to-earnings ratios as one of their benchmarks.

In the 1960s, growth investors appeared on the scene. Thanks to advances in technology, new businesses were sprouting up and growing very quickly. Of course, many of these new companies came public while still unprofitable. So, investors could no longer look to a company’s financial statements to measure its true worth. They realized that these small, growing companies would eventually generate tremendous, but currently-unknowable value. To deal with this obstacle, investors developed a variety of tools for valuing growth stocks. Measures such as price-to-sales and price-to-earnings became very popular, as did the practice of discounting future cash flows. Today, we take these things for granted.

Strong economic growth has fueled a tremendous interest in growth stocks. As a result, value investing has fallen out of favor. Many companies that are growing slowly have seen their stock prices stay flat. Indeed, the strongest performing stocks are companies that now possess, or are expected to eventually possess, very strong growth rates.

But when the economy slows, many expect stocks that represent value to become popular again. And remember, historically, value investors have done best in an economy that is growing slowly, shrinking or first showing signs of emerging from a recession.