Growth Stocks Investment

Posted by Ahmad Hassam

December 3, 2009

Capitalization or cap refers to the combined value of all the share of a company’s stocks. The division between large cap, mid cap and small cap are often blurry and not sharp. When you start looking for good stocks, you often come across these terms like large cap, mid cap, small cap, growth and value. Let’s discuss these terms for a moment.

However the following divisions are generally accepted: Large caps are companies with over $5 Billion in capitalization. Mid caps are companies with $1 to $5 Billion in capitalization and small caps are companies with $250 million to $1 Billion in capitalization. Anything below $250 million can be considered as micro cap. Now the most important term that you come across is growth stocks and value stocks. How do you determine this is a growth stock or a value stock? Perhaps the most important ratio is the Price to Earnings Ratio (P/E).

What is the P/E ratio? The P/E ratio divides the price of the stock by the earnings per share. Suppose, company ABC stock is presently selling for $50. Now suppose that last year company ABC earned $5 for every share of the stock outstanding. This means stock ABC P/E ratio is 50/5=10. So the higher the P/E ratio, the more investors are willing to pay for the stock.

Let’s make this clear with an example. Do you know how to read the balance sheet of a company? One of the most important things in doing research on a stock is the balance sheet of the company. Suppose, company ABC stock is presently selling for $50. Now suppose that last year company ABC earned $5 for every share of the stock outstanding. This means stock ABC P/E ratio is 50/5=10. So the higher the P/E ratio, the more investors are willing to pay for the stock. So what is the P/E ratio? The P/E ratio divides the price of the stock by the earnings per share. Over the years, studies have shown that the P/E ratio is somehow related with the growth of a company. Now the higher the P/E ratio, the more growth the company is supposed to have. So it can be either the company is growing real fast of the investor have high hopes of its growth. Now these hopes can be realistic or foolish, you never know!

Eugene Fama did seminal research on stocks and stock market s in’70s. Most of his results were startling and broke many myths. According to Fama and French, two famous researchers who did ground breaking research on stocks, over the last 77 years, large growth stocks have only seen 9.9% annualized rate of return as compared to 11.5% for the large value stocks.

Now intuitively you might have thought that growth stocks are better. What can be the reason for their lower performance over the years? The most probable cause seems to be their immense popularity. Since most of the headlines are captures by high growth companies, investors seem to think that they are the best investments.

Let’s go back to the IPO of Google. Think about Google, how its stock price shot up within a matter of weeks after it hit the market. Weeks after that it began to cool off. In 2007, Google stock was selling something around $500. So large growth stocks tend to get overpriced before you are able to buy them!

Mr. Ahmad Hassam is a Harvard University Graduate. Try these cash printing Forex Signals from heaven. Discover a revolutionary Forex Robot System! Get a totally unique version of this article from our article submission service

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Growth Stocks Investment

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