Investing in HIGH Growth, HIGH P/E companies

Companies with high growth are usually the darling of a lot of investors. However, there is a risk as well as a reward in choosing such options. In this post I am simply going to discuss some factors which every investor must keep in mind before simply going after 'high growth' companies.

The Risk involved
You have to remember that in majority of the cases, the fact that the company is growing rapidly is 'built into' the price. For example, if a company is expected to grow at say 10% per anum in the coming years, then people usually pay a price at around 10P/E, i.e. 10 times the EPS (actual price depends on other details, but roughly!). Now your high growth company, say is expected to grow at 50% per anum, then chances are that it is already trading at perhaps 50P/E! So already people are paying several times more for it than for other 'moderate' growth companies. The risk involved here is that the growth may not be sustainable. If suddenly, the next year is bad for either the company or the economy as a whole, then suddenly, the estimate of 50% growth will fall to 20% growth and the price of the share will plummet by a large percentage. This can essentially wipe out a big chunk of your investment in such a company. If you think its unlikely, look at what happened to real estate stocks in this recession, or IT stocks after the IT bubble burst. Ofcourse all stock prices have come down. But those high P/E, high growth companies have plummeted more.

The Reward
The reward is easier to describe. If suppose the company does sustain the expected growth, say 50% as in the above example, then in one year your investment will give returns of 50% ! The gamble or the skill involved is in actually deciding whether the expected growth is sustainable.

Words of Caution
There are a few things that you must remember are very dangerous.
  1. Do not invest in companies which are yet to start and which have high hopes of high growth. Take examples of RNRL, or Reliance POWER or IFCI. I dont know why these companies where trading at 100P/E at one point of time. RNRL is a classic example of a 'bubble'. While investing in high growth companies, it is important, or at least less dangerous to make sure that your high growth company actually has delivered the performance that you expect it will in the coming years. Gambling or Study based investing in companies which are yet to perform is a different ball game.
  2. It is important to keep a psychological bound on how high P/E you will trade. This will avoid you from staying away from bubbles. Personally i would be very uncomfortable investing in a company which is trading at say 60P/E. Yes, ok, maybe it has been growing at over 50% per anum, but is this growth really sustainable? So my self-imposed psychological barrier is 60P/E (which is already very high). Remember, during the peak of IT boom, Infosys was trading at 350P/E. It is not very hard to figure out that such a stock may be highly overvalued ! At least now, i can say so :)

Jan 25, 2009

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