There is no sense in reading a word about growth stocks until you have learned the fundamentals of general stock market investing. While some of the information is dated, this article from the 1960s contains a great basic understanding of how to guage growth stocks.
Of the many measuring devices used by security analysts to gauge the value of a stock, the price-earnings ratio is by far the most popular. In the last analysis, shares are part of business ownership and the purpose of business is to make money. If a company fails to earn money, its other assets, such as ground and machinery, are of little use. That's why investors pay less and less attention to things like the "book value" of a stock, and place more and more weight on earning power. It's the earning power that really counts!
Book value is obtained by adding the company's assets and dividing the sum by the number of common shares outstanding to get book value per share. Book value excludes such intangibles as management, patents, research and new product development though they are important in shaping the market price of a stock.
Price-earnings ratio is a much more realistic standard of measurement. Since every business is out to make money, it seems only logical to determine the price of a stock on the basis of the amount of money the company is able to learn.
The general practice is to price a stock on the basis of a company's latest 12-month earnings multiplied by a figure that varies depending on the market appraisal of a particular situation. Some stocks are evaluated as low as four or even three times earnings, while others as high as 30, 40, 50 or even more times.
The 425 industrial stocks composing the Standard & Poor index are selling at an average of 19 or so times their latest twelvemonth earnings. The more the market values a certain stock, the higher it places its multiplier, and vice versa.
If you have some idea about the kind of multiplier the market is likely to accord a certain stock, you should be able to get into the situation at a profitable level. The question is, of course, how?
Generally speaking, the 19 or so times earnings for Standard & Poor's industrial stocks is undoubtedly high, compared with 12 to 15 times earnings for the inflationary period of 1954-57.
Historically, the average ranged from a low of 7.4 in October 1906 to a high of 21.5 in May 1960. Some conservative-minded_ investors shudder at anything that violates the traditional rule of thumb that holds a stork should sell at approximately 10 times annual earnings.
To the majority of today's investors, however, this traditional standard of measurement is a yardstick of bygone days. To them, it is as outdated as old-time companies whose high-failure rate made stockholders insist on an annual yield of six percent for their risk. In order for a company to pay a six percent dividend, it had to earn 10 percent—hence the 10-times-earnings yardstick. This was, of course, before unemployment compensation, before the Employment Act of 1946 and before many other welfare economies of the Roosevelt and Truman administrations.
The nation's economic structure changed long ago. The vastly changed fundamental environment apparently accounts for the average investor's willingness to buy many stocks at prices that are considered high by the traditional standard.