By JACK HOUGH
Intuitive Surgical (ISRG),
That is tantalizing growth at a time when the broad Standard & Poor's 500-stock index is projected to see a 9% gain in operating earnings this year, versus 15% last year and 47% in 2010.
But investors might pause before buying Intuitive when they see the price: 36 times this year's earnings forecast, compared with 13 times for the S&P 500.
Other companies with strong earnings growth present a similar dilemma, including upscale grocer Whole Foods Market (WFM),
Deciding whether to pay a premium for growth stocks isn't easy. In general, investors should look for three things, says Bruce Olson, whose Wells Fargo Advantage Large Cap Growth fund has returned an average of 6.1% a year over the past five years, compared with 3.2% for its peers, according to Morningstar (MORN)
Finding robust growth seems like the easiest part -- just look at earnings per share. But keep in mind that any earnings growth driven by cost cutting and share repurchases might not last for long. Just as important is to look for increasing revenue, the hallmark of long-term growth.
"Organic" revenue growth, which comes from winning new business, is generally better for shareholders than growth fueled by acquisitions, experts say, because it tends to cost less and carry fewer risks. Management's discussion of operations in its quarterly reports often contains clues to how much of the growth is organic.
To tell whether earnings growth is sustainable, use a mix of qualitative judgments and metrics, says Tim Koller, a partner at McKinsey who advises companies on valuation. He favors companies with strong brands to those with merely hot products, such as the latest well-received iPhone competitor.
He also urges caution on businesses that continuously run up against large, new expenses as they expand, like many retail chains. And he looks for businesses whose customers would find it costly or inconvenient to switch to competitors -- think Facebook users deciding whether to tote their digital lives to Google Plus.
Spotting Sustainable Growth
Another place to spot sustainable growth is a measure called "return on invested capital," which is listed on some stock-quote websites. The measure shows whether companies are finding lucrative projects that can power future growth. Today, numbers in the 13% to 16% range are ordinary, while those above 30% are excellent, Mr. Koller says.
Technology giant Apple (AAPL)
Determining whether growth stocks are still reasonably priced is the most difficult part. Price/earnings ratios alone don't show growth rates, and complex financial models rely on making assumptions far into the future -- something even veteran analysts struggle to do with precision.
One simple alternative for investors is "relative" valuation, says Ken Smith, manager of Munder Growth Opportunities fund, which has an average five-year return of 7.5% a year, near the top of the pack for large-company growth funds, according to Morningstar. That involves comparing companies on a combination of metrics like P/E ratios and long-term earnings-growth forecasts.
For example, Priceline sells for 21 times this year's expected earnings and is projected by Wall Street to increase its earnings by 23% a year over the next five years. Rackspace Hosting (RAX),
Mr. Olson sees Google (GOOG) as
Of course, simple metrics like these can't tell investors everything. For example, Mr. Olson also likes McDonald's (MCD),
Mr. Koller favors another method for telling which growth stocks are worth their prices: working backward on the math. Use an online calculator to figure out what the share price would be after a decade of 10% yearly growth -- the market's historic average, not subtracting for inflation. For Chipotle, that would increase its share price from $398 to $1,032.
Next, assume today's high P/E ratio (about 46 for Chipotle) will have fallen to 15 a decade from now, roughly the historical average for stocks, because companies don't grow quickly forever. (Use a lower or higher number to make projections more conservative or aggressive.)
Then figure out how much earnings are needed to support the future stock price: about $69 a share for Chipotle. That would require it to meet Wall Street's $8.70 a share forecast for this year and boost earnings at a compounded rate of about 26% a year for the next nine -- no easy feat.
Next, an investor can turn these rough estimates into real-world comparisons and ask themselves whether the outcomes are reasonable. If Chipotle's earnings are to multiply eight times from this year's estimate, perhaps its revenues will grow that quickly, too. Such an outcome would give it yearly revenues of $22 billion a decade from now. Over the past year, Starbucks (SBUX)
On a similar basis, Mr. Olson says Chipotle is too expensive for his tastes. Mr. Smith says he doesn't own many restaurant stocks, including Chipotle, because "they're often faddish until they're not."
Above all, investors should keep in mind that with fast growth comes the possibility of a swift tumble if that growth slows. P/E ratios in the high teens or even low 20s don't increase an investor's risk significantly, Mr. Koller says. "But once you get above 25 you'd better have a very clear understanding of the long-term potential for the business."