High growth stocks are some of the most sought after in stock markets around the world. Drawn by the prospect of exponential earnings growth, investors are often willing to pay high prices for consistent top and bottom line expansion.
However, the hunt for the next Apple (NASDAQ:AAPL), Amazon (NASDAQ:AMZN) or Facebook (NASDAQ:FB) can drive valuations of these high growth stocks to dangerous levels at times. Growth can quite quickly come to an abrupt halt and share prices can plummet as a result. In these periods of prolonged market volatility, it is important to be extra alert when it comes to high growth stocks.
Sticking to a tried and tested strategy can be a good way to filter out riskier high growth stocks. One way of doing that is to use what's known as Price to Earnings Growth investing. Pioneered by the investment guru, Jim Slater, a strategy of picking high growth stocks trading at relatively cheap valuations when compared to their earnings has proven to be a popular approach over many decades.
Here's how Alpha Financial Markets Consulting (LON:AFM) rates against this strategy...
Growth at a reasonable price
Companies with a track record of impressive earnings growth often command high valuations. Finding bargains amongst high growth stocks can therefore be a challenge. The Price to Earnings Growth (PEG) ratio can be used to identify stocks trading at cheap prices when compared to their growth rates.
To calculate the Price to Earnings Growth on a rolling basis, we take the historic Price to Earnings Ratio and divide it by the consensus forecast Earnings per Share growth for the next year. A PEG ratio below 1 is considered to be favourable, whilst a PEG ratio below 0.75 is an indicator that a company might be undervalued compared to its current rate of growth. Alpha Financial Markets Consulting passes this test with a PEG ratio of 0.60 at the time of writing.
Elephants don’t gallop
One of Jim Slater’s most famous quotes was that “elephants don’t gallop”. By this, he was highlighting how larger companies, with multi-billion pound market capitalisations rarely double in size. However, smaller sized companies are a relatively under-exploited area of the stock market. There is less broker coverage and investor appetite amongst small caps, so this is where, with sufficient due diligence, investors can find undervalued and overlooked stocks with greater potential to multi-bag.
To identify these smaller sized companies, we look for market capitalisations below £1 billion. Alpha Financial Markets Consulting meets this criteria, with its current market cap standing at £216.8m.
What does this mean for potential investors?
Finding growth stocks at reasonable prices is a popular strategy with some of the world's most successful investors. But be warned: these factors don't guarantee future returns and we've identified some areas of concern with Alpha Financial Markets Consulting.
Disclaimer: These articles are provided for information purposes only. The content is not intended to be a personal recommendation. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser. The author has no position in the stocks mentioned, unless otherwise stated.